Seeking Alpha
Long/short equity, growth, commodities
Profile| Send Message|
( followers)

Gold miners are being hammered lately. Is there any reason to pick up the pieces yet or is there just more to come? The once beloved mining companies have performed poorly over the last few years. If we compare the two-year chart of the S&P 500 with the Market Vectors Gold Miners ETF (NYSEARCA:GDX) we can see that the divergence started in September 2011. Stocks started a rally, which has still not ended. Gold miners started to drop, which eventually led into the heavy selling mid April. Why are these stocks not participating in the stock market rally and when is the time to pick them up?

(click to enlarge)

Combined S&P 500/GDX graph source: yahoo.finance.com

The reasons for the S&P 500 rally are commonly known. Although there is disagreement on the validity of some, the markets seem to have started their bull run on a combination of factors:

The aggressive stimulus programs undertaken by several central banks to boost growth are the main reason. Central banks have pumped trillions of dollars into the financial markets. This money drove down the yields on government debt. This made other assets (shares) more attractive. Another reason for the positive vibe around stocks was the diminishing risk of a break-up of the eurozone. For years now European countries have been struggling to restore faith in the joint currency and with the help of the ECB, yields on European bonds were finally decreasing. The markets were also betting that the U.S. economy would improve in the second half of the year along with the emergence of Europe from recession and a soft landing of the overheated economy in China.

Now gold mining companies are of course extremely sensitive to fluctuations in the gold price. Since the start of the decline of DGX in September 2011, commodity prices have declined substantially, but not dramatically. On September 5, gold reached an all-time high of $1921 per ounce, caused by a poor jobs report, the ongoing eurozone debt crisis and lingering uncertainty around the U.S. debt ceiling crisis. At the end of 2011 stocks and gold miners started their divergence. Stocks moved up slowly but steadily, gold miners went the other way. One year later, on September 13, 2012, the Fed announced QE 3: a $40 billion a month, open-ended, bond purchasing program of agency mortgage-backed securities together with the extremely low rates policy until at least mid-2015. Later that year the Fed expanded the amount to $85 billion a month. This was the deathblow for the gold miners. With the extra money flowing into the market, belief in a healthy recovery of the economy returned to investors' minds. This was the turning point in the financial markets. The gold price weakened further and stocks were the place to be.

(click to enlarge)

Source: traderdannorcini@blogspot.com

Looking back we can see a reversal pattern in September 2011, which seemed to have marked the top of the gold chart for several years now.

Gold Miners declined by 55%

So the reversal in the gold market was also the start for the decline of the gold miners' index. Now the gold price declined from a market top of $1900 to $1450 right now. That is a decline of $450 or 23%. The GDX, logically, set a top at the very same time. But since then it has declined by 55%! Why have these gold miners been hammered so badly? One reason I could find is that a lot of gold mining corporations have been poorly managed. The companies have not anticipated a decline of the gold price but instead kept on believing in higher prices. In the past five years, gold miners have been investing heavily in new explorations, new equipment and work force in order to keep up with the extra demand for gold. But the cost price of an extra ounce of gold has risen steadily. In a very interesting article from Hebba Investments I learned that production costs for Newmont (NYSE:NEM) Mining Corporation, one of the biggest gold miners, in the 4th quarter of 2012, went up to $1295 per gold ounce equivalent. With the current gold price hovering around $1430 there is little room left to stay profitable.

Some gold mines have already been closed due to the lower gold price. In Australia, Tanama Gold and Focus Minerals are closing some of their mines because of the current gold price. Especially Australian gold mines have been hurt by higher costs because of the higher wages down under. When mines close, the amount of gold added to the gold market will decline, which eventually should have an upwards effect on the gold price.

Where to look for as a gold miner investor?

Investors have to be very careful picking up gold miners. Although they look rather cheap, it can be very enlightening to first take a look at the fundamentals of the company you want to purchase. The problem lies in the fact that it might have to raise new capital in order to stay in business, to do the necessary investments or to stay competitive. Mining companies have had a wild ride and have not all been well managed. With a gold price of $1800, everyone could make money, but right now cost control is very important. The balance sheet can tell you whether loans have to be extended in the near term. Liquidity and solvency are the financial ratios to keep an eye on.

Conclusion

The declining gold price and the huge costs mining companies are making are responsible for the absence of the gold miners in the current stock rally. With gold prices declining, miners have to work hard to get their costs under control; cost control is priority number one. However, for the long term, miners will always be attractive because of the fact that they own the commodities in the ground. Commodities will be subject to price fluctuations and miners will have to deal with that. Only mining companies with effective cost control can survive in times of sinking commodity prices. If you want to be exposed to mining companies at these levels, take a good look at their balance sheets and costs per ounce gold before you take action. Taking a long position in one of the weaker mining companies could easily end up in tears. Only companies that can prove that they can adjust their cost price rapidly to the market price of gold are worth the try.

For investors who can't wait, an exposure to the gold price itself might be more attractive and safe right now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.