Gold mining stocks have spent the past year going nowhere in what is essentially a wide trading range that looks like a complex corrective formation. What is so surprising is that this has coincided with a big rally in gold and a shift in silver prices to a much higher trading range. To this it should be noted that many of the mid tier gold miners produce significant amounts of silver as a byproduct, while both the major gold stock indexes (HUI and XAU) contain a few component stocks of primary silver producers.
There are several reasons why the stocks of gold miners have failed to reflect higher metal prices. There two fundamental reasons: one is the fact that their input costs have risen in tandem with the gold price. Everything from labor to energy (the two most important input cost factors) to steel and chemicals has become far more expensive. The other is that the big gold mining firms have acquired a reputation for being less than astute in their employment of capital. In order to 'buy growth' or merely to replenish mined out reserves, they often engage in expensive acquisitions that in many cases require significant additional capital investment before they produce a profit. Since not only mining costs but also mine development costs have been rising sharply, this has led to a combination of shareholder dilution and a lack of dividend growth. Both of these fundamental factors are changing now (see further below).
Another reason is psychological. The bull market in gold and silver has been disbelieved by the majority of market participants all the way up. We are not referring to the CTA's (commodity trading advisors) and hedge funds here that are the major speculative traders in gold futures. These two groups can be considered trend followers – as a rule, they don't try to second-guess strong trends.
However, in the mainstream investment world, gold has yet to find acceptance. It is the asset people 'love to hate' for some reason – presumably the fact that it 'pays no dividend' and is not amenable to the same type of supply-demand analysis as industrial commodities both play a role in this refusal to consider its investment merits. We suspect that the fact that gold challenges the modern-day economic orthodoxy is also a reason for the hostility some people harbor against it.
This orthodoxy of course holds that we need a centrally planned 'flexible' fiat money to ensure smooth economic development – and it is probably one of the costliest economic errors since the Bolsheviks established socialism. Gold's bull market is a constant and embarrassing reminder that the markets are losing their faith in the monetary bureaucracy.
Ironically, it is this very disbelief that has helped to keep the bull market alive – since it has ensured that many investors remain on the sidelines, representing a large reservoir of future demand. After all, gold is in a bull market that is based on sound fundamental reasons – so bit by bit, former doubters are turned into believers. And yet, the expectation that the bull market will soon end has inter alia weighedon gold stocks over the past few years. The perceived risk of buying stocks at the peak of the cycle is very likely a major consideration that has kept investors away.
The HUI Index of unhedged gold stocks has been going sideways in a corrective formation in spite of the big rallies in gold and silver – click for higher resolution.
The HUI-gold ratio shows that the gold stocks have weakened against gold since early April – click for higher resolution.
However, the earnings reported by gold mining firms last quarter not only showed that costs were still rising, they also gave a strong indication that these firms nonetheless enjoy a lot of earnings leverage to the gold price. Even companies that failed to exceed 'Street expectations' (this 'expectations game' is complete nonsense anyway, but even more so in the case of mining companies) showed large year-on-year increases in free cash flows and earnings. Meanwhile, gold in the ground in the form of reserves and resources has obviously become far more valuable as well. As the gold price rises, lower grade ores that were not economically viable before have become so, and gold mining firms are economizing by mining some of these ores in order to lengthen the life of their mines.
Moreover, it appears that the managements of gold mining companies have finally decided it is time to listen to the pleas of investors to raise their dividends. We haven't kept precise tabs on it, but a great many producers have in fact raised their dividends lately, with several pledging to continue to do so.
Given that the gold price was quite a bit lower last quarter than it is at present, reasonably strong earnings seem set to continue even in the event of a gold price correction.
Lastly, the most important factor in gold mining profitability is of course the difference between mining input costs and the gold price, not the level of the gold price as such. Gold has a peculiar characteristic: in times of growing economic uncertainty and during recessions, its price tends to rise against the prices of all other goods. This is due to gold being the only form of money the supply of which can not be increased at will. Since the demand for money tends to increase in times of declining economic confidence, the gold price will tend to rise against other goods in such time periods. As a consequence, gold mining stocks are the only market sector that exhibits a long term inverse correlation with the broader stock market. In the short term, this is often obscured by factors such as declining market liquidity, but in the long term it is undoubtedly the case. For example, the S&P 500 was at roughly 1,500 points in the year 2000 when the gold bull market began, while the HUI index hit a low of 35 points in the same year. Today the SPX trades at 1180 points, while the HUI trades at 564 points (a decline of approximately 21% versus an increase of over 1,500%).
In short, during secular contractions, gold and gold mining stocks are a much better investment than the broad stock market. Given that secular contractions historically last between 16 to 25 years, this is likely to remain the case for a good while yet.
Recently economic data have once again deteriorated globally – not surprisingly, gold has therefore begun to rise strongly against everything else. Gold mining firms have just experienced a big boost to their profit margins and eventually this should be reflected in their share prices.
