This article is really about potential
energy. The coming gold stock mania is gathering essential potential ahead of
the most exciting capital growth opportunity we may witness in our lifetimes.
As if this was not valuable enough, it will occur as other assets continue to
devalue. This is the role of gold for investors in a crisis. For the banks it
may well assist them to regain confidence once it is completely lost.
Before I get into this discussion, we
need to check a number of factors. I need to begin with a basic and that is
that there are a limited number of gold producers on a global basis.
Investors will get crowded out of physical and there will be a scramble for gold
stocks in all markets due to their rarity.
China remains the world’s number
one gold producer however it is a net importer. This means that the growing
production is not able to keep up with their growing demand. I have read this
figure may be as high as an additional 400 tonnes of gold per annum, over and
above the 360 tonnes produced on a per annum basis (as of last year). This
reduces the annual global supply of gold back to circa 1,700 metric tonnes.
The world’s next largest producer of gold is Australia with around 265
tonnes in each of 2010 and 2011. Australia does export gold and therefore it
contributes to fresh global supply.
The Australian gold stock sector is
therefore one of significant importance. I should qualify this statement to
maintain integrity. It is true that several offshore majors are operating in
Australia and they do contribute to that production figure. However the ASX
producers (domiciled in Australia) also operate mines internationally and
this offsets the adjustment. Newcrest is the major contributor to this
however there are several more ASX listed gold companies with operations in
Asia, Africa and even parts of Europe.
We have a special group of rapidly
growing gold producers that should outperform the top heavy global producers
which are struggling to maintain their resources. The special group of miners
here are developing mines and growing production as they establish themselves
for future benefit. Most of this group of stocks have seen their share prices
fall as their operations have improved. The main irony however is that this
fall in share price has occurred just when their incomes finally began to get
well clear of their total cost.
This is occurring because gold has risen
faster than their costs since late 2008. I have completed a study that looks
closely at this and quantifies the anomaly. They represent stunning value and
as gold rises again this increases exponentially. I have conducted
independent research to quantify their relative value across this gold rally
to date and the valuation levels in this sector against gold. Finally I added
the main ingredient which is profitability. I have been able to simplify this
into a single figure which has greatly pleased my accountant & other
professional clients.
Before I go into this further, the
points I want to discuss would be moot in isolation. One must consider the
top down analysis to establish the likelihood of a continuation of the trend
which might reverse the gold stock malaise we have endured as gold stock investors
over the past 18 months.
Take Australia as an investment
destination. We have a stable political system and I do expect the current
minority government to be resolved in the final quarter next year at the
upcoming election. Our politicians are fairly typical of their peers around
the world unfortunately. When they are not spinning their agenda or bragging
about the work actually done by the corporations and real work force they are
making life harder for us not easier. I will not sit here and claim Australia
is the ultimate destination due to our stable financial system; I would not
want to insult anybody. It is comparatively acceptable however at this stage.
I believe I need to periodically test my
overall thesis and investment strategy. This also involves constant attention
to detail as I monitor the markets and signals I receive. It is nice to see
elite Funds backing up my analysis on Australia. The likes of BlackRock and Van Eck have been, and by recent
substantial holder reports, appear to continue to soak up extreme oversold
levels in this gold sector. Good luck to them; for they are gradually
positioning themselves in many of the same stocks I have represented in my
Educational Portfolio at higher weighting levels.
Over recent months I have monitored gold
and the gold stocks closely in relation to the ongoing global financial
crisis. Back in April I produced Newsletter 55 for Members which investigated
and quantified the relationship between the Australian gold sector and the
Australian price of gold. This has been a continuing confusion for most
investors. This relationship is very important because most of the domestic
miners earn their returns here in Australia in our dollar (AUD).
Speaking of the Aussie gold price here
is a chart showing the magnificent uptrend.
Alpha is king
As you can see above the Australian gold
sector is enjoying the strong AUD gold price. As the AUD falls the sector
becomes cheaper for offshore investors especially in the USA. There is some
downside risk, on the AUD (for US investors) at present due to a slowing
China and troubles in our banking sector. Global funding issues are adding to
the problems of the local banks, with their dilemma also due to falling real
estate prices. I believe the RBA here will be forced to gradually lower their
interest rate to support the banks here. This is not without consequences
however the pressure has set in. As the AUD falls the gold stocks will enjoy
a rising AUD gold price. This will increase their earnings and eventually
this translates into alpha.
This is especially important in these
economic times as alpha is king. Alpha is just a professional term for yield.
Even despite the risk on the banking sector here at present we have decent
yields in this sector which is holding up their share price. As the
global investment community seeks to maintain their wealth in a deleveraging
world they will flock to yield. This will be one of the more significant
capital flows in the coming decade. Flows not chasing alpha will be seeking a
safe haven which will require lack of counterparty risk.
I suggest investors take care to
establish a model which can reliably factor risk on the sustainability of
yield moving forward however. If yield is not sustainable in your chosen
investment class, stand clear you may be looking at a top. Gold stocks
however have an increasing yield and the potential for further gains going
forward is highly favourable. Despite their growing earnings their share
prices have been savaged in line with the rush to liquidity. This is the
increasing potential energy I describe, potential capital growth.
Where is gold
now?
I strongly believe that this gold
consolidation phase is just that. It is yet another sideways movement to consolidate
former gains and to gather energy for a new up-leg. I have read some talk
that even physical gold is a risk asset which is quite ludicrous for the
simple reason that is has no sovereign or counter party risk. The real reason
it sold off in risk off events of the past few months was related to
liquidity. This same phenomenon was last seen in the 2008 bank crisis however
it passed quickly. Gold bottomed just seven months after the March 2008 high.
In this consolidation phase gold has made a new bottom (triple) nine months
after the recent high. Gold and equities sell off first because they are
liquid. Capital flees (initially) towards the USD and bond market because
they are liquid.
‘QE to be or not to be’ has
become a trigger mechanism for gold price movements during this consolidation
phase and yet M2 growth remains at +10% growth post QE2. Therefore this whole
argument makes no sense either. We have argued that ultra-low interest rates
are a form of stimulus and could also be considered to be a form of QE. This
is all about the adjustment to a low growth world after a long debt binge
which grew to unsustainable levels. This created the banking crisis which
then shifts to a sovereign debt crisis as the banks are bailed out by
governments. The stimulus is an attempt to maintain the status quo and slow
deflation.
Interest rates will remain low (negative
real interest rates) and other assets will continue to come off. Instability
and volatility will remain in the global financial system in the coming years.
No wonder gold is tracking at this new higher price plateau. In this
environment gold will eventually continue on its uptrend.
This will cause the gold stocks to
become more profitable over time. The gold price consolidation is gradually
drawing to an end which is the very reason the large Funds are accumulating.
They cannot get set too quickly or they force prices higher in the process.
The northern hemisphere summer could see a firming of the gold price as
Europe simmers. The bond yields are blowing out on Spain and Italy at this
time. The chances are that we either get a massive QE sovereign bond purchase
here or we get a disaster. Both outcomes would be highly gold positive.
From a technical perspective we hit a
triple low, with the last low divided and clumped into three dips during May
with a buy divergence. This has since seen a bounce on June 1st
with an $80 range, straight up hitting a falling Bollinger Band (I use 20
day, 2 standard deviations). The minor correction that followed stabilized at
the 20dma and now we have started a longer bounce rising up towards a now
rising top Bollinger Band. This is a bullish pattern. I will leave the timing
of the coming break out to other commentators however my guess would coincide
with the end of the northern hemisphere holidays based on the monthly
patterns and general gold market. For now I am expecting the gold price to
firm up a little and consolidate a little higher or print a false break out
ahead of the real event. Those of us watching this from the start have seen
it all before.
How
undervalued?
Now to the quantity of undervaluation I
promised you above in the title and opening paragraph. The following is part
of Newsletter 55 from April this year.
“At the end
of April 2001 gold traded at US$255.45 when the XGD was just 993.25 at a
ratio of 3.8882. This was at the end of a 20 year bear market and only
marginally below the low reached in the 2008 melt down. In effect the 2008
low retraced the entire bull market in gold stocks going back 7 years (at the
time) and this is understandable; by 2008 the cost of production had risen
significantly across the industry. What I am saying is that with gold at
those extreme lows in 2008 it was equivalent to a gold price of $255 in
margin terms due to the rising cost of gold production over those 7
years.”
This is not the
full transcript however I followed up with this: “Now what
about an update – are we there yet? I have added some new calculations
and research below and slotted the key readings in to appropriate positions
for easier comparison. This may not be clear without some careful reading
however I urge you to take some time as it will provide clarity on your
position or future decisions.”
Date
|
Apr 01
|
Oct 08
|
Now
|
May 05
|
Aug 09
|
Oct 06
|
May 06
|
Mar 08
|
Sep 11
|
Gold
|
255.45
|
682.8
|
1639.8
|
413.75
|
930.3
|
559.4
|
730
|
1030.8
|
1,920.8
|
XGD
|
993.25
|
2,674.4
|
5,776
|
2,186.4
|
4,614.7
|
4,052.2
|
4,928.2
|
6,921.5
|
7,995.3
|
Ratio
|
3.8882
|
3.9168
|
3.522
|
5.2844
|
4.9604
|
7.2438
|
6.7510
|
6.7147
|
4.1625
|
$A:US$
|
0.4778
|
0.6012
|
1.0244
|
0.7522
|
0.8445
|
0.7736
|
0.7793
|
0.9471
|
1.0764
|
Agold
|
534.63
|
1,135.7
|
1600.7
|
550.05
|
1,101.6
|
723.24
|
936.74
|
1,088.4
|
1,784
|
Aratio ©
|
1.858
|
2.355
|
3.608
|
3.975
|
4.189
|
5.603
|
5.261
|
6.359
|
4.482
|
“Ratio” (line 4 above) is
simply the XGD (Australian gold index) divided by the USD gold price. I have used
the XGD extremes (low and high) and the gold price at that time for each
column. The next line down (running across) is the AUD: USD ratio each
measurement. Agold is the next line; it is simply
the AUD price of gold for that time. The bottom line is the AUD adjusted
Ratio figure which actually adjusts each figure to the AUD price of gold.
This is essential to make sense of the AUD gold price as earnings of the
sector are controlled by that number. I have copyrighted the Aratio© number as it is part of a more important
number. A bit more from the Newsletter to clarify my thoughts:
“The top three rows of data are
simplified numbers so I have added the three lower rows inside the box. The
margin on gold at US$255 in 2001 was deplorable for the global industry
however the AUD: USD ratio at the time meant that in AUD terms our gold
producers were earning A$534 per ounce. This did not mean Aussie gold stocks
were in favour however. The deep pessimism from investors caused them to
overlook this sector but who could blame them it was 2001.
I was finally able to make sense of the
2008 panic low which, once adjusted came in under the current level and above
the pre-rally launch date in 2001 as it should. After all the rally was 7
years on, sentiment had changed towards gold, it was awake at last. Yet at
the time the end of the world was apparently close. The sky was burning and
we were about to head back to the caves if you believed the hype at the time.
Markets had been in ‘free-fall’ for months. Before the adjustment
for the AUD it appeared that the GFC low was as bad as the pre-2001 gold
launch, and that this low right now was below both.
Before the beginning (2001) the Aratio was at 1.858 – that was after 20 years of
bear market and as you would expect this should be the lowest point for the
ratio. The adjusted 2008 figure makes more sense at 2.355. Now as we head under the earlier lowest sentiment induced ratio lows of 4 (May
2005 and August 2009 columns) we have to consider that a low may be
close.” As you can see above we now have a simplified number to
indicate value in the market for this sector.
Another important observation when you
look at the figures:
“What I do find interesting is
that when I use the Fx exchange rate to filter the
levels achieved by the XGD in the lower box in this table above we even out
the result. Look at the tops in the XGD in terms of the Aratio:
May 06 = 5.261, March 2008 = 6.359, November 2010 = 6.04 and April 2011 =
5.946. They were all quite similar and this gives us a more reliable frame of
reference to measure tops from. A level of around 6 should indicate a danger
of a correction and stops and / or that caution will need to be used. NOTE: When the eventual mania arrives
this figure will keep rising and trailing stops along with an exit strategy
will need to be used.
The September 2011 high in gold at
US$1920.8 did not see a follow through rally on the stocks which drastically
underperformed the metal. This statement still applies when you factor the
AUD price of gold to create the XGD ÷ AUD$gold
= the Aratio©. At this stage of the rally the
gold stocks and the Aratio achieved, were very
poor, barely reaching 4.482. Since then gold corrected and the gold stocks
have followed it down even faster, this cannot last long.” This leads
us along a path as this picture is still not quite complete (again from the
Newsletter):
Something
missing here?
There is another important factor left
out of this research train of thought however; and that is ‘cost of
production’. We have to be careful to get this right or we could end up
comparing apples to oranges. Therefore to complete this line of reasoning we
have to consider the profitability factor. Cash costs are confusing across
the industry because they are not standard. Royalties and other factors vary
from company to company and lease to lease.
To be
continued next week…
Good trading / investing.
Neil Charnock
Editor, Goldoz.com.au
REGISTERED ADVISOR – WHO THE ADVICE COMES FROM
IN THE GOLDOZ NEWSLETTER:
Colin Emery is currently a Branch Manger and Senior Client
Adviser of a Stock Broking Company in Queensland Australia. Prior to his work
in Share broking he spent nearly 20 years in Senior Management and Trading
positions in Treasuries for major International Banks such as Bank Of
America, Banque Indosuez, Barclays Bank, Bank Of
Tokyo and Deutsche Bank AG. He spent a number of years as a Senior trader in
New York, London, Singapore, Tokyo and Hong Kong with these institutions. He
also was Global Head of emerging energy, emission and commodity products for the
leading Energy and Commodities brokerage firm of Prebon
Yamane Ltd – Prebon Energy for four years
before moving to Cairns in 2003 to focus on the Stock market and Private
consulting work. The private consulting and advisory work currently
undertaken is with companies involved in Resources, Energy and Renewable
Energy and Forestry.
Neil Charnock is not a
registered investment advisor. He is a private investor who, in addition to
his essay publication offerings, has now assembled a highly experienced panel
to assist in the presentation of various research information services. The
opinions and statements made in the above publication are the result of
extensive research and are believed to be accurate and from reliable sources.
The contents are my current opinion only, further more conditions may cause
my opinions to change without notice. The insights herein published are made
solely for international and educational purposes. The contents in this
publication are not to be construed as solicitation or recommendation to be
used for formulation of investment decisions in any type of market
whatsoever. WARNING share market investment or speculation is a high risk
activity. Investors enter such activity at their own risk and must conduct
their own due diligence to research and verify all aspects of any investment
decision, if necessary seeking competent professional assistance.
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