Back on May 18th, 2012 I wrote a piece titled Jumping Into The Abyss: A Bull Case for Gold Mining Stocks. The miners had declined 40% from their August 2011 highs and for a variety of fundamental reasons like valuation and the relationship between mining costs and the price of gold and technical reasons, like sentiment, I felt the case to buy was compelling. The stocks subsequently rallied more than 30% over the following 4-5 months. In the 4-5 months since, stocks have given back all of those gains and some more, leaving them down an additional 9% or so, with the majority of losses occurring in the last few days. All this has happened in the context of gold trading in a similar pattern, but with more modest gains and losses.
HUI Gold Bugs Index and Gold (GLD) 05/18/2012 to 02/20/2013
A reader emailed asking for a brief update so here it is.
It's Darkest Before Dawn
While I don't think this is necessarily true in nature, it certainly seems to be in investing. As dark as things seemed for miners last spring and summer, the subsequent rally reminded investors that where there is value, there will eventually be returns. It is likely a sign of how short term focused this market is, that sentiment rapidly turned quite bullish on gold and mining stocks AFTER they rallied into the fall. Well, here we are again, right back at extremes in sentiment.
This is true for gold itself among both the public and gold focused newsletter writers who are recommending a paltry 6.3% net long position and this way back when gold was $1,650/oz (last week). I suspect this recommendation will have moved to a net short position by now, which would be in line with previous periods of extreme pessimism and near term gold weakness.
The mining stocks have been even weaker than the metal itself. Not surprisingly, sentiment on the gold mining stocks is extremely negative, the only sector of the stock market with such a reading.
Okay, so the miners, along with gold, have given back all their gains from last spring and sentiment is once again quite negative. Is that enough to support another rise from here? Will the next rise be any more sustainable than the last? To answer those questions, let's quickly return to the fundamentals.
Fundamentals: Then vs. Now
Back in May 2012, I wrote
While buying mining stocks here could certainly look foolish in the near-term, NOT accumulating positions, or selling them for that matter, is likely to be the bigger mistake over the long term.
Gold mining stocks are attractive here for three primary reasons:
1. The sentiment on gold, and gold mining stock in particular, is at extreme bearish levels.
2. They are historically very cheap by a variety of relative and absolute measures of valuation.
3. The macro environment is likely to turn very supportive, thereby improving the fundamentals of the stocks, reversing the negative sentiment, and driving the valuations higher.
I believe we are more or less in the same place today, with valuations being even cheaper on some measures. On the macro environment front, I believe the markets are being fooled by the rhetoric out of the Fed, without looking at their current and likely future actions.
Gold mining stocks remain cheap by almost any objective measure.
One way to look at mining stocks is to compare them to the price of gold itself.
Here is an updated look at the HUI mining index relative to gold itself. It is hitting new lows.
Comparing miners to the price of gold itself, shows miners are cheaper today than they have been in decades.
As I wrote in May, while instructive, this measure doesn't do you a lot of good if the price of gold is set to drop precipitously, an issue which I'll address. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman from a few years back:
source: John Hussman,
However, the miners are also cheap on a variety of traditional metrics such as price to earnings and price to cash flow ratios. Today they are roughly similarly valued as they were in May as earnings and cash flow estimates have come down somewhat. Here are the updated charts.
Consider the trailing, current, and estimated ratios depicted for these three large mining companies. While one must be careful of future estimates of operating metrics and the consensus estimates are likely to be wrong in some way (please see my prior post), when I see single digit P/E ratios and mid single digit price to cash flow ratios, I pay attention.
Of course, the true value of the mining stocks resides not simply in their ability to generate cash flow over the next few years, but in the intrinsic value of the resources that the companies can reasonably expect to extract. Even with long-term gold price estimates well below current prices, the stocks are trading cheap relative to their estimated Net Asset Value. The following chart shows the senior mining stocks price to estimated Net Asset Value courtesy of BofA Merrill Lynch.
source: BofA ML February 19, 2013 Report
Determining whether or not an investment is attractive requires understanding WHY something is mispriced, as understanding market expectations is equally important as fundamentals.
In May 2012, market expectations for gold stocks seemed to relying on two key assumptions:
1. The price of gold will not go up significantly and may have a long-term average well below today's price.
2. The costs for mining will continue to grow at a fast rate, negatively impacting margins and earnings growth.
Today, the market expectations for gold's decline seem to be even stronger as investors consider the prospect of the end to the Fed's accommodative policies. The expectations for costs and margins remains largely the same, despite qualitative signs that currently strong margins will be protected.
These are Mr. Market's errors– and therein lies the opportunity for astute contrarian investors.
Concerning the price of gold…
Back in May 2012, I argued:
what appears to be completely absent from the market's current assessment of gold and silver mining stocks is the likely actions by the Fed and other central banks in the coming months and years in response to lower trend growth in global GDP and the ongoing sovereign debt crisis. In a point made by colleague Brian McAuley in a series of recent client letters, the Fed and other central banks will likely print a lot of money in the coming years in response to slower economic growth and high government debt levels.
Sure enough, by September we got the latest installment of QE by the Fed, which is not so much an installment, but an open ended promise, currently slated at $85 billion worth of bond purchases a month, and one I wrote extensively about in QE n+1 What The Fed Is Really Up To. We have also seen a strong move towards expansionary policy at the Bank of Japan.
However it didn't take long for enthusiasm for the gold-as-hedge-against-monetary-expansionism meme to dry up. In January, the Fed released its December minutes which highlighted several FOMC members concerns about the sustainability of current policies.
That bit of rhetoric seemed to cause a slide in the price of gold which has continued throughout the new year. It was also exasperated by the release of the January minutes highlighting more worries that its current stimulus measures could result in instability in financial markets, and may be difficult to remove in the future.
If gold weakness is in fact a result of this rhetoric, gold owners have nothing to worry about. The Fed is not about to execute on any sort of exit.
We discussed this with clients in our Annual Letter which will become publicly available in a few months.
Anyone who is familiar with the basic math of the deficit and debt can see what would likely happen if the Fed stopped buying at this point, let alone started *selling* their holdings. The more they buy as this decade rolls onward, the more they can't sell without the government running into a funding crisis. In fact, we are likely already beyond the point at which the Fed can't even stop buying without creating a funding crisis. We discussed this in our November 2012 Client Letter. And yet, they need to keep talking about exit strategies in order for the obvious to be a little less obvious, or perhaps to somehow satisfy the doubt deep down in the own consciences. It's worth noting that there are even fewer hawkish consciences voting at the Fed in 2013 than there was in 2012.
Beyond the forward looking assessment of the Fed's ability to exit given structural deficits and the lack of political will to address them, there is always history. We could look at past instances of the Fed "exiting" or reducing the monetary base after past periods of "temporary" monetary expansion. We could do that sort of analysis if such a thing had ever happened. In fact, it never has.
There was no "exit" from the 1929–1945 monetary expansion. In fact, since 1918, there have been no significant, lasting declines in the monetary base.
Gold is one of the assets most sensitive to central bank monetary expansion, and in this sense, the price of gold is merely following the lead of the Fed and other major central banks. The growth in the monetary base is one way to look at gold from a value perspective, as it rises roughly in concert with the money supply, and the chart below shows the same rise in the monetary base, this time accompanied by the price of gold. After Nixon ended the convertibility of dollars and gold in 1971, the price of gold-- then unchained from the official exchange rate-- quickly caught up with the cumulative growth of the monetary base. And in fact, as most bull markets do, during the parabolic rise at the end, it probably overshot its value.
Today, gold appears undervalued relative to the growth in the monetary base that has occurred up to now. In light of the monetary expansion the Fed and other central banks are currently undertaking, gold appears more undervalued. The Fed's current quantitative easing program probably won't be curtailed until households stop deleveraging and the government can handle the rising interest expense on its expanding debt.
Yet, in the face of all this, many gold mining stocks are now selling at valuations that suggest the market has priced in a decline in the price of gold back to 2007 levels, before the Fed began expanding its balance sheet during the financial crisis. Many gold mining stocks are now selling near or below their book value, which is the market's way of saying that these businesses won't be able to add shareholder value in the coming years by mining gold and silver. If the price of gold were to decline below $700 or so, it would certainly be the case that most mining companies wouldn't be able to profitably sell gold. Yet such a decline in gold is the main implied assumption being priced in by the market today, and this has sent valuations of gold mining stocks to their lowest levels since the current bull market began.
Concerning the price of everything else…
Back in May, I highlighted how much costs to mine an ounce of gold had increased and how investors were extrapolating those rising costs. And while cash costs for 2012 appear to be coming in right at the levels forecasted back in May, analysts are using much higher forecasts for 2013 and 2014. This despite subdued prices for both crude oil and copper, two decent proxies for mining company costs.
Qualitatively, mining company executives are getting religion regarding ambitious capex programs and are working to secure margins, focusing on profitability over production. We have seen several recent executive firings at major mining companies that show boards are serious about protecting shareholder value.
Bringing It All Home
I wrote back in May that:
...if mining stock prices are being held back by a negative view of the gold price and concern over input costs then the shares should rally if either one of these conditions is resolved favorably. The input costs for miners will decline if the economy weakens from here. The reversal in the price oil the last few weeks seems to be confirming this view. At the same time, it seems likely that evidence of further economic weakness, regardless of the origin, is going to be met with a policy response that will benefit gold.
We saw glimpses of that last fall causing mining shares to rally by 30%.
Today, investors will need to start watching what the Fed and other major central banks are actually doing, as opposed to saying, and with it will come a realization that gold is likely headed higher, not lower. One of the first places that realization should benefit is gold mining stocks.
As I wrote back in May, the timing of these events is highly uncertain, but not really that important. The incredibly cheap valuations for mining stocks, coupled with the extreme bearish sentiment, provides for a substantial margin of safety. Mining company stock prices look to be falling BACK into the abyss; I am there waiting for them with open arms.