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 include 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 CTAs (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 weighed on 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.
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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.
The HUI-gold ratio shows that the gold stocks have weakened against gold since early April.
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 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.
Gold's Relative Price
Gold has been rising strongly against all fiat currencies, as well as commodities, stocks and bonds of late. In spite of the strength in t-bonds and many non-dollar currencies, gold has still managed to outdistance all of them. The rise of gold against commodities is what is most relevant to gold mining margins, especially gold's rise relative to energy prices. Below are a number of charts illustrating these developments. Long time readers may recall that we wrote about a similar phenomenon before, back in the depths of the 2008 financial crisis. Even though gold's nominal price (i.e., its dollar price) fell at the time due to a strong rally in the US dollar as a global scramble for dollar liquidity took hold, its price still rose strongly against commodities, boosting the profit margins of gold miners. It is interesting to note in this context that this was one of the occasions where the market was simply wrong, or rather, an occasion where technical factors (the need to become liquid coupled with averse market psychology) temporarily overrode fundamental factors (rising profit margins), creating a rare buying opportunity in the sector. So much for the efficient market hypothesis – the knowledge that profit margins in the sector were rising was not enough to keep the gold stocks from trading at a vast discount and ironically the discount only narrowed again when these favorable conditions actually became less favorable in the subsequent commodity price rebound.
Gold relative to the CCI (continuous commodity index, the equal-weighted version of the CRB) – in a strong uptrend since February.
Gold vs. the CRB Index – it has been even stronger vs. this commodity index that contains a heavy energy weighting.
Gold relative to crude oil – this is incidentally the highest level in this ratio since early 2009, around the time the stock market produced its crash low. As energy is one of the most important input costs in gold mining, a high gold-crude oil ratio is a great boon for the industry's profit margins.
Gold vs. platinum – platinum is a precious metal as well, but one the supply-demand characteristics of which are far more akin to that of an industrial commodity, whereas the bulk of gold demand is largely monetary, or investment demand. It is therefore logical that gold's price will rise against that of platinum when economic confidence declines. Note by the way that we think platinum's fundamentals are bullish as well, even though it is currently hampered by perceptions about the economy.
The gold-silver ratio shows that gold has also been rising against silver lately, a warning sign for the economy akin to widening credit spreads (in fact, credit spreads have been widening concurrently). Silver is the hybrid among precious metals – it is regarded as both an industrial and a monetary commodity and over the past year the latter characteristic seems to have grown in importance.
Gold vs. the 10-year treasury note over the past two years. Treasuries may still be in a bull market in dollar terms, but they are in a bear market against gold.
In terms of profit margins, gold mines situated in countries with strong currencies have struggled to profit from the bull market. This is no longer the case, as gold's price has lately broken out to new high ground even against the strongest so-called commodity currencies. In fact, as far as we are aware, the only currency in the world against which gold has not yet reached a new high is the Swiss franc, but even against this strongest of all fiat monies it has recently strengthened and has maintained a bullish-looking chart.
Gold in terms of the Australian dollar. Gold mining margins down under are rising strongly as well now.
Gold in Canadian dollar terms – this is new high ground as well.
Gold in terms of the South African rand. South African producers are the most marginal (highest cost) producers in the world. The move in the rand gold price should provide an especially strong boost to their profit margins.
The Swiss franc has been the only viable competition for gold in the currency arena (ironically, just like gold, it has no yield). Even so, the chart of gold in CHF looks favorable to gold.
The other safe haven currency, the Japanese yen. Gold remains in a strong bull market in yen terms as well.
Gold in terms of the misnamed pound sterling – the uptrend has accelerated.
In euro terms, gold has been very strong as well – we previously remarked on the bullish gap up over the old high. This is a case where a gap has turned into support.
Below is the ratio of gold to the Dow Jones Steel Index and Lumber. Note that the ratio to the steel index is an imperfect way of looking at things, as the index consists of steel stocks, but as this paper (pdf) shows, the share prices of steel stocks are actually a fairly good leading indicator of steel prices. Also, the charts of various steel prices themselves (see world steel prices) show that while steel prices have been rising, they are still quite a bit below their 2007/8 highs, i.e., gold has been rising more strongly. Steel and lumber are both important input cost items in mining.
Gold vs. the Dow Jones US Steel Index.
Gold vs. lumber – this is a new high as well.
Here is gold in dollar terms – the recent advance has been near parabolic and a correction seems likely, but even if prices come back a little, the profit margins of gold miners should remain strong.
Finally
The stock prices of gold mining stocks do not yet reflect the increase in gold mining margins – not even the margin increase that has already occurred as per recently reported earnings, not to mention the additional margin increase provided by gold's recent rise against commodities. It is unknowable when the market will reassess the situation, but it seems highly likely that it will be reassessed at some point.
Note here that in the latter half of the 1970's gold bull market, it also took a while before gold stocks finally reflected the higher profit margins provided by the rise in the gold price (holders of gold stocks had to go through a frustrating period of underperformance from mid-1976 to roughly mid-1978, while the gold price rose strongly). In fact, gold stocks rose to a higher high relative to gold in the second half of 1980 after the bull market had ended. This double non-confirmation (first gold made a higher high in January of 1980 concurrent with a lower high in gold stocks, followed by the exact opposite in September 1980) was in fact one of the signals that indicated that the bull market had come to an end. There is no way of knowing how exactly things will play out this time, but it is always a good idea to keep in mind what has happened in the past. Meanwhile, the Fed's recent promise to keep its short term interest rate at zero for a minimum of two years is quite bullish for gold itself.
Should gold stocks eventually break out from the trading range that has pertained over the past 10 months, a strong move can be expected.
