Five straight days of gains and the best week we've had in over six weeks. The markets are finally showing some life. But is this all a grand illusion? Despite the negative news engulfing the world markets, stocks are not only holding up but have seen a tremendous rally this past week. Perception is reality and it looks as if investors are thoroughly expecting a big round of stimulus coming from Bernanke as he takes the stage at the two-day FOMC meeting on September 20-21. While this may appear to have helped our markets, it could also lead to disaster.
If investors are buying based on the sentiment that a new and significant amount of stimulus is coming, but the stimulus doesn't come, you can expect the markets to sell off. We need news of a strong stimulus package if our markets are going to survive to see next year. I am going to reiterate the fact that we should all be watching the next week as if it were our last. Even with stimulus, we still have to look at what the other side of the world is doing.
How to guarantee a double on your money?
The European issues have only gotten worse. The Greek bond markets have gone off the scale. Yields have risen by 150 percentage points on some bonds in the space of three months and volumes have slumped to practically nothing.
As a matter of fact, one three-year bond, which was trading at 20 per cent in June, is trading at a yield of 172 per cent, with a bid-offer spread - the difference between what a bank is offering to buy and sell the bonds at - of 47 percentage points. That's worst than most of the illiquid junior stocks on the TSX Venture. Earlier in the week, yields on one-year Greek bonds climbed to more than 130 percent. No, I am not kidding. 130% yield on one year bonds.
If you believe Greece will survive by helping them out now, they'll give you more than double your money back. Where in the world can you find a government-backed investment like that? But guess what? Even with those yields, investors are hardly jumping at the chance to buy them. That's because at the end of the day the other European nations (especially Germany who's carrying the Euro on its back), will eventually say enough is enough. When something is too good to be true, it probably is...
Whether our markets like it or not, Greece should default, and default big.
But if they do, we will see a snowball effect all over the world. The question is can it be contained? Bernanke better have a trick up his sleeve next week for the sake of our short term markets.
Bullion for Paper
There's no doubt that the most common question I get from readers is: "Why is there such a disconnect between gold prices and the price of gold stocks?"
There are many reasons but they all boil down to one simple thing: sentiment. First off, many sell-side analysts use outdated or extremely low gold price numbers to value gold stocks - despite the strength in the price of gold. That's because of the notion that the higher gold goes, the worst shape our financial system is in and therefore, the worst shape the economy is in. If the bearishness remains, equities will falter and analysts base their estimates on the state of the markets. They believe that if stocks fall, gold stocks will too - as they did in 2008.
But this way of thinking doesn't factor in that gold stocks have enjoyed a tremendous run in prices, climbing nearly 1000% from the lows of November 2000 through to August 2008 (based on the HUI Gold Index, a basket of unhedged gold stocks). If you go back through those years, you would see that the juniors had a phenomenal run up in prices as well.
That's not the case today.
Many of the gold producers are now trading at far less than five times two-year-out forecasted earnings based on today's prices. As a matter of fact, many of them are trading at less than three, even two, times two-year-out forecasted earnings.
As I fully expect gold to continue its climb, many of these companies will be trading at less than one time two-year-out forecasted earnings. History will tell you that any time you have a company that's trading at those valuations, 9 times out of 10 you have a winner.
Also consider that on average, producers are paying roughly $800/oz to pull gold out of the ground. At today's price of over $1800/oz, they're capturing $1,000 per ounce in EBITDA. Try finding another sector with that kind of profit margin.
Another reason why gold stocks have lagged is because of the volatility in the price of gold - but not gold itself. I know it sounds confusing but it's actually very simple.
Most of what is determining gold's price is paper trading - which is fundamentally flawed. The amount of paper gold and silver contracts that trade on the futures and equities exchanges easily outweigh the amount of actual physical trading that takes place.
That means it's the paper markets setting the price discovery for gold. It means that sentiment, and manipulation, are the causes of gold's volatility and not the physical fundamentals of gold itself.
In a report published earlier this year (see Before it's Too Late), Eric Sprott and Andrew Morris pointed out the significant discord between paper and physical supply on the Comex relating to silver:
...Over 800 million ounces traded each day in April on (the Comex). Further, consider that as at the end of April there were only 33 million ounces of registered inventories to back up all of that paper trading. Just imagine if a mere 5% of all of that buying actually stood for delivery; the entire inventories would be more than wiped out.
Over a year ago, I published a letter that revealed how most of the gold that is traded in the markets are not actually fully backed by the actual metal itself, as many believe (see The Silver Conspiracy): For years, most people have assumed that the London Bullion Market Association (LBMA), the world's largest gold market, had actual gold to back up the massive "gold deposits" at the major LBMA banks. But it doesn't.
This was confirmed during the CFTC hearings when Jeffrey Christian of the CPM Group said that the LBMA banks have approximately 100 times more gold deposits than actual gold bullion. This means that for every ounce of gold traded in these markets, 99 of them appear from thin air. Has gold and silver been converted into a fiat currency in these markets?
In the LBMA market, for example, an average of 19.6 million ounces of gold was traded per day in July. The world has produced on average approximately 2,497 tonnes per year over the last several years - which is just over 80 million troy ounces. That means the LMBA trades nearly a year's worth of worldwide gold production in less than a week.
While gold production has been stable, it's certainly not growing much. When new mines are developed, they're mostly serving to replace current production, rather than expanding global production levels. That's because gold production experiences comparatively long lead times, with new mines taking up to 10 years to come on-stream. That means mining output is relatively inelastic and unable to respond quickly to a change in price outlook - as we have seen in recent years.
Even a sustained price rally, as experienced by gold over the last seven years, doesn't translate easily into increased production.
Consider that while the LBMA is essentially trading a year's worth of production in less than a week, it doesn't factor in the amount of trades on the COMEX futures and other major gold ETFs. If you combine all of these exchanges and funds, the amount of gold traded and the actual amount of gold available is staggering.
Therefore, gold's price discovery is clearly out of sync with true fundamentals. When the price of gold is dictated by paper contracts with extremely leveraged physical backing, the price can swing very dramatically. In a market where volatility has investors running for the ropes, the end result is a sentiment that drives them away from gold equities.
But that is now slowly changing.
There have already been many days in the past month or so where gold has fallen, but gold stocks have climbed. There have been days when the Dow has fallen, but gold stocks rallied. There have been days when gold climbs, and gold stocks climb even higher. All of these minor events prove to me that things are changing: that gold stocks are beginning to shine, so to speak. That is why I have told many of my close colleagues, money managers, and our readers since June to start trading bullion for stocks.
Back in June, I said to go long on the gold producers.. A few weeks ago (see The Russian Secret), I explained the profit potential if you invested in the major gold producers early June, as I had explained. Despite the run up in prices, gold and silver stocks - in particular the juniors - are still lagging behind.
That means there is still time to participate in the rise of gold - without having to own gold itself (although I still suggest gold and silver as a portion of everyone's portfolio).
While I am bearish on the world economy as a whole, that doesn't mean I am bearish short term - especially not in gold equities. The market can still rally and with it, we may see new highs. The market has been strong last week but with five straight days of climbs, profit-taking could be on the table.
But again, we're going to have to wait and see what Big Ben has planned for us next week at the FOMC...
Disclosure: Long Gold and Silver ETFs, and major gold producers.