Gold Stocks Are Ready to Reignite

by: Bruce Pile

Investors seem to be fretting about a weakening recovery as the numbers continue to disappoint and stocks are showing signs of fizzling. And then there's the looming end of QE, a huge fuel source for money going into the stock market. So what's a gold fan to do regarding gold and silver stocks? There is a school of thought that says all "risk-on" speculation positions are vulnerable. And that includes miners of anything - even gold, and especially silver with its heavy industrial use. Gold stocks have been a dog lately, so is now the time to sell or buy?

Some instructive comparison can perhaps be drawn by looking at the last time we had an obvious slowing economy coming at us. This was over the last half of 2007. So how did gold and silver and the associated stocks behave in '07 as the weak economy started taking hold?

First, let's look at how well the discounting of the market was working during this period by looking at Dr. Copper, the commodity with the PhD in economics:

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Here we see that the doctor was right in seeing the approaching recession coming as usual. The key 140/200 day ema (blue and red lines) broke out of its bull mode with collapsing divergence in November. So if you had the same angst about all economy sensitive commodities, you perhaps would have been a seller of silver at this time with its usage being primarily industrial. Gold during this period moved up sharply. So silver had a choice to either follow its monetary partner, gold, with a historical R squared correlation of something like 0.9, or to follow its economic partner, copper. Which did it do? Here is the silver chart for that period:

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If there was ever a time for silver to decouple from gold, it was late 2007 when we were going into a ginormous recession with copper rolling over. Silver obviously chose to follow its monetary partner and track gold's strength in '07, breaking with copper, even though there was absolutely no currency crisis at the time! The situation we have now is an economic slow down, but in the context of a recovery cycle, not going into a great recession, but coming out of one. And we most certainly do have a mega currency crisis now, making it far more likely that silver will follow its monetary partner than its economic cycle partner this time around. The economy is weakening, and copper is weakening; but silver probably won't be following this weakness - barring a repeat of an '08 collapse.

Both gold and silver are likely to ignore a double dip threat. But what about the stocks? As any holder of gold stocks has whined of late, the miners have been under-performing the metal for what seems like forever. These things run in cycles, and we probably are at a major turn point in that regard. If you look at it fundamentally, you would look at something like the ratio of gold stock price with the NAV or net asset value of their gold reserves. This value factors in the current best estimates of production cost per ounce, etc. and, as a recent article at American Century Blog points out

Recent analysis focused on the senior gold-producing companies shows that these shares traded for much of the last decade at a modest market value premium of about 1.3 to 1.5 times their net asset value. That P/NAV ratio dipped below 1 only once during that period, at the very height of the financial crisis in late 2008. But the failure of the stocks of gold miners to keep up with the recent surge in the price of the metal means this ratio is again below 1.

The only other time besides now that the miners' most basic valuation metric was below 1.0 is at the bottom of the horrendous '08 crash! You would have to say that is a fundamental analyst's extreme. You reach the same conclusion from a technical analyst's perspective:

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Here we see the gold/gold stocks ratio charted. This ratio goes up when the metal is outperforming the miners and vice versa. Since the market bottom in '09, this ratio has moved in a channel. The recent surge to new highs in both gold and silver since March has left the miners flatfooted; and we are at an extreme position at the upper end of the channel now, and probably turning into a new period of gold stock out-performance. So if the metals are likely to rise, the stocks will be rising faster.

The climb in oil prices along with higher chemicals and commodities in general as well as a ramp up in mining personnel pay, have kept a half nelson on the precious metal stocks. But perhaps as important as higher cost is a general skepticism about the rise of gold and silver pricing.

Silver in particular obviously had too much "hot money" distorting its price up recently for a couple of months, and the silver stocks were conspicuous by their absence from this rally. They totally did not follow this gyration. But with leveraged hot money largely washed out of silver now, and a currency crisis proceeding apace, the skeptics may slowly be converted in a new phase in the gold stock cycle.

Disclosure: I am long AGQ, DGP. I am long an assortment of gold mining stocks