Gold And Mining Shares - It's Better To Travel Than Arrive

 |  Includes: GDX, GLD, IAU, RING
by: Philip Morrish

There is an old stock market saying, "it is better to travel than arrive," and it's one that every investor should heed. Bull markets do not run indefinitely, most especially if the trajectory is near vertical.

The following chart clearly shows that gold (bullion) has enjoyed a stratospheric rise since its bull run started in 2001/02 but investors remain divided over its next movement.

Chart: Gold Bullion (US dollars/Troy ounce)

Click to enlarge.

Click to enlarge

Source: ©Intelligent Analysis

Gold bugs (bulls) continue to believe that the gold market bull-run is sustainable (and currently is only pausing for breath) and that it will touch the giddy heights of $3,000, because the global economic crisis is not resolved, particularly within the Eurozone. Moreover, they assert that mining shares have yet to fully participate in this bull-run, as was the situation during the 1970s when, apparently, there was a delayed response to the gold market's bull-run.

The bears, and I count myself as one, argue that gold has run its course and will continue to underperform from here on out. It also means that mining equities have either fully participated or missed the boat.

For the record, we are not recent converts to the bearish camp. On the contrary, we were one of the first to publicly state that the gold market's bull-run would blow out during the second half of 2011, and when the bubble burst, the gold price would fall sharply.

The standard gold bug arguments are that gold is a safe haven investment because it is a non-tarnishing, limited resource, which makes it a good investment to preserve capital, particularly during periods of economic uncertainty. It is also a good hedge against inflation. This is an interesting concept because gold would need to rise to around $2,400 per troy ounce to match its inflation-adjusted 1980 high. Moreover, Central Banks are going to hoover up hundreds, if not thousands, of tons of gold to provide support for their valueless paper currencies, particularly the US dollar! They also assert that, as in the 1970s, mining stocks have not yet fully participated in this bull-run.

That latter argument is frighteningly asinine! Financial markets and the various traded asset classes are significantly better connected than during the 1970s, and information is more effectively disseminated and instantly acted upon. The following chart dispels that myth because it clearly shows that mining shares were rising about 2 years in advance of the meteoric ascent in gold bullion and other commodity prices during the well-publicized commodities super cycle. Indeed, the ratio of the FTSE Mining index/Gold Bullion ("ratio" legend in the following chart) widened from an historic average of 10.1x (20/4/1994 - 21/4/1999) to a peak of 32.9x on 19 May 2008, since when the ratio has contracted and was 11.1x on 15 May 2012.

It is important to note that the ratio's sharp fall during 2008/09 reflects investors' heightened concerns about the depth of the synchronized global recession and the emerging scale of the financial crisis, i.e., a short-lived flight from equities, which included mining shares. That aside, the overall steady decline from the ratio's peak reflects the dual influences of a moderation in the forward equity earnings growth rate for mining shares due to the substantial capital raised by the sector as well as gold prices catching up with equity investors.

Chart: Gold Bullion and Ratio of FTSE Mining/Gold Bullion (ratio)

Gold Bullion & Ratio of FTS Mining/Gold BullionClick to enlarge

Source: ©Intelligent Analysis

We maintain our long-held opinion that gold will resume its previous role as a minor asset class because, contrary to popular opinion, the global economy is in relatively good health and growing. This is consistent with our earlier opinion that a tactical asset reallocation began during the second half of 2011. Indeed, it is only the economies of the UK and Eurozone countries (with the exception of Germany) that are either contracting or stagnating. The Greek drama will have its final curtain call soon, and whatever the outcome, the other southern Eurozone states will be sufficiently protected and supported by the European Central Bank and Germany.

Nevertheless, we continue to believe that the future economic growth rates for all the developed economies will be less than their historic trend rates due to the on-going rebalancing of their respective economies through exacting deficit reduction programs. In turn, this will have a moderating influence upon the future economic growth rates for the emergent economies (e.g., BRIC countries). It should be noted that these economies are all at varying stages of shifting their economic development focus from infrastructure investment toward domestic consumption, which is another nail in the coffin for the commodity super cycle.

The major trading currencies, with the exception of the Euro, should remain relatively stable. The Euro will remain volatile until the Greek crisis has been resolved. Thereafter, it should begin to strengthen as the Eurozone member states complete the realignment of their respective economies to that of Germany.

The following two charts clearly demonstrate that there is a good correlation between gold bullion and the FTSE Mining index. The unadjusted chart is a plot of the data from 20 April 1994 until 15 May 2012. The adjusted chart provides a clearer picture of the correlation because it shifts the Gold Bullion data back two years to align it with the start of the equity advance as well as excluding the 2008/09 flight from equities data from the FTSE Mining Index.

Charts: Gold Bullion & FTSE Mining Index (20 April 1994 - 15 May 2012)

Gold Bullion & FTSE Mining Index (unadjusted)

Gold Bullion & FTSE Mining Index (adjusted)

UnadjustedClick to enlarge

adjustedClick to enlarge

FTSE Mining Index (LHS) [blue line]
Gold Bullion US$/Troy ounce (NYSEARCA:RHS) [red line]

Click to enlarge

Source: ©Intelligent Analysis

In conclusion, there are no fundamental economic arguments that can support either a sustained consolidation, let alone a further rise in the Gold Bullion price. While a constructive resolution of the Greek drama and Eurozone debt problem would kick away any remaining sentimental support for gold.

Equity markets appear to have begun to discount this scenario because the FTSE Mining Index is testing current support levels. Moreover, the substantial issuance of new equity by opportunistic mining groups, especially the explorers, will increasingly act as a future earnings drag resulting in longer-term underperformance. Therefore, we would anticipate that the FTSE Mining index will initially test the 15,000 level before moving down to consolidate at the 10,000 level, or lower if the commodity super cycle has ended. Therefore, on the assumption that the FTSE Mining/Gold Bullion ratio returns to its traditional 10.1x multiple then the gold bullion price could quickly fall to $990 per Troy ounce.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.