Don't Fear a Normal Gold Correction
US Global Investors
By Frank Holmes
October 26, 2012
Don't Fear a Normal Gold Correction
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
I’ve spent the latter half of the week at the New Orleans Investment Conference, talking with investors, mining companies and analysts about the state of the gold industry. The annual conference falls at an interesting time of the year, as the price of gold typically corrects in October. In fact, going back 30 years, the historical seasonality of gold has been to rise during September, with a subsequent correction in October.
This fall, gold has followed this historical trend, with the metal climbing throughout the month of September to reach a high of $1,790 an ounce on October 4, only to have a normal correction to $1,701 by October 24. This decline typically comes ahead of the Love Trade fueling demand prior to the Hindu festival of lights, Diwali, which begins in November.
Miners, Show Me the Money!
At the conference, I’ve been discussing the multiple forces squeezing the profits and earnings out of gold miners, causing equity investors to become the Rod Tidwells of the gold world, getting miners energized to “Show me the money!” In my opinion, this phenomenon highlights the importance of selectively choosing among those gold companies that exhibit the best relative growth and momentum characteristics to help obtain outstanding investment results.
My workshop presentation in “The Big Easy” integrated preeminent thinking from multiple gold experts, including research firm CIBC, Gold Fields and the World Gold Council, about how gold companies’ performance has been neither “big” nor “easy.” There’s been a decline in production per share, an 80 percent increase in the average cost per ton of gold over the past six years, and a 21 percent decline in global average grades of gold since 2005. Cash taxe s per ounce of production have increased dramatically, and, according to CIBC World Markets, the replacement cost for an ounce of gold is now $1,500, with $1,700 as a sustainable number. Cash operating costs eat away the most, at $700 an ounce, while sustaining capital, construction capital, discovery costs, overhead and taxes eat up $800. At the October 24 gold price of $1,700 an ounce, only $200 is left over as profit, says CIBC.
Gold companies have had their share of challenges in the past. Prior to the huge run-up in gold prices in the late 1970s, forward price-to-cash flow ratios crashed from a high of about 22 times to just under 9 times. Eventually, as gold climbed to its high, multiples spiked back up to 21 times.
Miners also didn’t increase the supply of the precious metal in the 1970s. Back then, there were only a few major players in the gold game. South Africa was a significant gold-producing country, as well as Russia and North America.
However, following years of a gold bull market in the 1970s, production climbed. In fact, Pierre Lassonde, chairman of Franco-Nevada and a living legend in the mining and resource world, says it took seven years for the gold industry to respond after the rise in the price of gold. Ironically, as the price kept falling over the next 20 years, production doubled, says Lassonde.
Beginning in 2000, gold companies have experienced a similar phenomenon, with production remaining flat, even declining in some years. In 2008, mine supply of gold fell to levels not seen since the early 1990s.
Now, after a seven-year lag, the industry has responded as we’re beginning to see some growth in supply.
From 2006 through 2011, production throughout the entire gold industry has increased about 3 percent, says CEO Nick Holland of Gold Fields. During his keynote presentation at the Melbourne Mining Club in July, he indicated that most of the growth was not coming from the major producers. In more mature markets, such as South Africa, Australia, Peru and the U.S., annual production decreased by about 5 million ounces since 2006. Emerging markets on the other hand—China, Colombia, Mexico and Russia—added about 7.6 million ounces over the last six years, Holland says.
Of gold finds that contain at least 2 million ounces of gold, research from the Metals Economics Group (MEG) finds that there have been 99 significant discoveries between 1997 and 2011. Only 14 of the 26 major gold producers made these major gold discoveries. “Today, the major producers and their majority-owned subsidiaries hold 39 percent of the reserves and resources in the 99 significant discoveries made in the past 15 years.” This amounts to less than half of the yellow metal needed to replace the gold companies’ production from 2002 to 2011, says MEG.
According to Lassonde, this is the “elephant in the room,” as new finds have become elusive. The chart below from CIBC shows that there was only one major discovery that was more than 3 million ounces in 2011. Over the past seven years, there have been only nine major discoveries of gold.
Lassonde doesn’t think we have hit “peak gold,” but believes the gold industry needs a “3D seismic” event similar to what occurred in the oil industry before we see considerable finds.
For as many challenges as gold companies face today, they have rarely experienced such a well-diversified consumer base and diversified demand for their product: It’s “the best we could ask for,” says Lassonde.
A newer trend that I’ve discussed is the reemergence of emerging markets central banks as buyers of gold, as they have been “relearning that all paper currencies are suspect,” says Lassonde. Today, he says “cash is trash,” with the value of euro, dollar and yen in question.
He believes this source of demand could be long-lasting and quite significant if you look at emerging market countries’ gold holdings as a percent of total reserves. In 2000, the European Central Bank decided that the right proportion of gold to own should be 15 percent. Pierre says if you apply that figure to the potential gold holdings of the emerging market central banks, they would need to accumulate 17,000 tons of gold. At a purchase of 1,000 tons a year (or about 40 percent of today’s production), these central banks would have to buy gold for the next 17 years!
Another growing source of demand has been from the Fear Trade’s scooping up of gold exchange-traded funds (ETFs). Eight years after the products were launched, 12 gold ETFs and eight other similar investments are valued at around $120 billion and hold 2,500 tons of gold, says Nick Holland.
I believe the Fear Trade will continue buying not only gold but also gold stocks, as the group is driven by Helicopter Ben’s quantitative easing program. In the latest Weldon’s Money Monitor, Greg Weldon discusses the consequences of the Federal Reserve’s debt monetization and liquidity provisions, showing the “somewhat frightening pace” of expansion in money supply.
Weldon says that over the last four years since August 2008, the U.S. Narrow Money Supply, or M1, which is physical money such as coins, currency and deposits, has increased 73 percent, or more than one trillion dollars. This is about as much as it expanded in the previous forty years!
Don’t let the short-term correction fool you into selling your gold and gold stocks. The dramatic increase in money suggests that monetary debasement will continue, and in addition to all the above drivers, I believe these are the positive dynamics driving higher prices for gold and gold stocks.
- The major market indices were down this week. The Dow Jones Industrial Average fell 1.77 percent. The S&P 500 Stock Index dropped 1.48 percent, while the Nasdaq Composite declined 0.59 percent. The Russell 2000 small capitalization index closed the week with a loss of 0.94 percent.
- The Hang Seng Composite fell slightly by 0.03 percent; Taiwan fell 3.71 percent, while the KOSPI declined by 2.70 percent.
- The 10-year Treasury bond yield was little changed falling 2 basis points for the week, to 1.74 percent.
Domestic Equity Market
The S&P 500 Index fell 1.48 percent this week as most of the decline came on Tuesday on apparent disappointment in Apple’s release of the iPad mini and other product refreshes. Earnings season is in full swing and many have disappointed again this week.
- The health care sector was the best performer this week but still fell 0.84 percent. The sector tends to be defensive in nature, and this week was no exception. The best performers were from a variety of industry groups but the medical instrument and equipment group experienced broad-based strength.
- The technology sector also outperformed, even as bellwether names such as Apple and Amazon reported disappointing earnings results. The technology sector was the worst performer last week and much of the bad news already appears to be priced in.
- Varian Medical Systems was the best performing stock in the S&P 500 this week as the company rose by 14.5 percent after it reported earnings and revenue that exceeded expectations. Oncology-related sales were particularly strong and the company was able to overcome the macro headwinds that have bedeviled many this earnings season.
- The materials sector was the worst performer, falling 2.8 percent. The sell-off was broad-based and encompassed most areas of the sector from steel to chemicals to mining.
- The energy sector also underperformed as oil prices (WTI) fell 4.25 percent this week and then combined with a handful of earnings disappointments.
- Newfield Exploration dropped by more than 20 percent and was the worst performer this week in the S&P 500. The company announced on its earnings call that its international oil volumes could be down as much as 25 percent in 2013, much worse than analysts were expecting.
- While debasing the value of its paper currency in the long term, renewed money printing in the developed world may have the ability to send asset prices higher in the near term.
- The market is clearly focused on earnings announcements and the upcoming elections, which could cause some volatility.
The Economy and Bond Market
Treasury bond yields were essentially unchanged this week as economic data was mixed, the Federal Reserve was status quo and the financial markets focused on corporate earnings announcements.
Consumer confidence continues to move higher as the University of Michigan Consumer Confidence Index hit its highest level since the financial crisis. Sentiment is improving due to lower gasoline prices and higher property values. This is an interesting dynamic as the economic headlines indicate little improvement, and in many areas worsening economic conditions. This shows the power of housing and the wealth effect it has on consumer sentiment.
- The University of Michigan Consumer Confidence Index hit its highest level in five years and is confirmation of other similar surveys of consumer confidence.
- New home sales rose 5.7 percent in September, while the months’ supply of new homes hit a seven-year low.
- Third-quarter GDP rose 2 percent, in line with expectations and a modest improvement over the second quarter.
- Capital goods orders in September fell 10 percent on a year-over-year basis and have been in a declining trend for months.
- On a related note, Caterpillar lowered its 2012 outlook for the second time this year, citing European weakness.
- Spain’s unemployment rate hit 25 percent in the third quarter, the highest since 1976.
- There remains considerable speculation about the prospects for near-term government policy action in China that would support the economy or stock market.
- Interest rates are likely to remain very low for the foreseeable future, both here in the U.S. and globally.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.
For the week, spot gold closed at $1,711.30, down $10.45 per ounce, or -0.61 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 0.89 percent. The U.S. Trade-Weighted Dollar Index gained 0.48 percent for the week.
- Agnico-Eagle and Goldcorp reported strong third-quarter performance. Agnico-Eagle improved operations at the Meadowbank, Kittila and Pinos Altos mines, and as a result, the company increased its full-year gold production from 975,000 ounces of gold to 1,025,000 ounces. Scotiabank analyst Tonya Jakusconek observed, “Agnico-Eagle delivered three consecutive quarters of solid operating performance, and has kept conservative production targets for the last quarter of 2012.” Goldcorp beat analysts’ earnings per share expectations, which helped mitigate the pain of operational challenges during the first half of the year. “This is the sort of thing the market is looking for: under-promise, over-deliver and contain your costs,” George Topping of Stifel Nicolaus told Reuters Thursday. Agnico-Eagle gained 5.62 percent this week and Goldcorp gained 1.08 percent.
- World central banks are buying more gold. Brazil added 1.7 tons in September and Turkey added 6.8 tons. India tends to buy more gold at this time of year because of the jewelry demand for the wedding season and festivals. Central bank buying is expected to continue, given the lower price and currency risk in the developed world.
- The shift out of paper proxies for gold, and into the metal itself, is visible. Total gold coins and bar purchases are up 96 percent since 2009, while net additions to ETFs are down 73 percent over the same period. The shift from paper to physical metal is even more dramatic in silver. Investors have tripled their silver bullion purchases since 2007, while the exchange-traded vehicles sold 26 million ounces more than what they bought to back their funds last year.
- After eight weeks of consecutive increases, gold’s net speculative length fell last week. Standard Bank attributes gold decline to investor uncertainty over the ability of QE3 to support prices and/or the longevity of the Fed’s open-ended commitment to easing. UBS writes that it makes perfect sense that gold would outperform other risk assets in anticipation of QE, but underperform during the aftermath.
- Harmony Gold lost close to 13,000 ounces of gold to date due to an ongoing illegal strike at its Kusasalethu mine. This equates to around 20 lost production days or 22 million in lost revenue at the current gold price.
- AngloGold Ashanti, Gold Fields and Harmony have signed a deal with unions that will see adjustments to workers’ pay being made under the existing two-year wage agreements as proposed on October 9. Stability in the gold mining industry has been achieved at many operations and there are hopes that this trend will continue.
- The Comstock Lode is a rich silver and gold deposit worked in Nevada mostly in the second half of the 19th century and centered on Virginia City. John Winfield, now chairman of Comstock Mining, started to consolidate the land holdings in the Virginia City area back in 2003 and since then a significant portion (about 10 km long) of the Comstock Lode District has been consolidated into single ownership under Comstock Mining. The first gold and silver pour was achieved towards the end of last month.
- A deflationary scenario—triggered by slowing world GDP growth—could potentially place downward pressure on gold prices, Mineweb stated this week. In this scenario, if one assumes the “fear factor” does not overwhelm deflationary concerns, then a possible 30 percent decline, similar to 2008, is at least conceivable. That would put prices at roughly $1,300.
- UBS observed the relative lack of momentum in current gold prices, pointing out in a note this week that, “It is clear right now gold is lacking the drive to charge higher.”
Energy and Natural Resources Market
- The Baltic Exchange's main sea freight index, tracking rates for ships carrying dry commodities, gained about 6 percent this week as rates for larger capesizes remained strong on Chinese iron ore demand.
- China released commodities final trade stats this week for September. Refined copper imports rose 17 percent from August due to restocking ahead of the October national holiday.
- The iron ore market has experienced a healthy recovery over the past month, nearing the $120 per ton level. This recovery has been a result of several factors, the most important of which include: (1) rising steel prices as domestic inventories are drawn down, (2) a decline in iron ore inventories at Chinese ports, and (3) an apparent pick-up in economic activity in September (fixed asset investment up 20.5 percent year-over-year).
- Reuters reported that JFE Holdings, Japan's second-largest steelmaker, has slashed its full-year profit forecast in half due to worries that a delay in the recovery of Asia's steel market and slower demand from carmakers will squeeze margins. Japan's steel producers are also likely to suffer from a decline in demand from carmakers after the government ended incentives in September 2012 for environmentally friendly cars.
- September trade statistics showed that Chinese net coal imports dropped 2.2 million tons month-over-month.
- The price for domestic crude oil fell below $90 a barrel this week on further concerns over Europe and slowing economic growth globally.
- HSBC’s Flash China Manufacturing Purchasing Managers’ Index increased to 49.1 in October, from 47.9 in September, which beat consensus forecasts and suggests a sequential upturn in China’s manufacturing activity. A range of data released in recent weeks, from increased exports (up 10 percent year-over-year in September) to rising retail sales (up 14 percent year-over-year in September), also suggest economic growth is gaining traction, supported by stimulative government policy and spending. However, headwinds remain in key export markets.
- A report from IHS Global Insight shows the United States shale boom will continue its rapid growth to support three million direct and indirect jobs by 2020. The analysts predict unconventional oil production in the U.S. will overtake conventional oil by 2015 and reach close to 4.5 million barrels per day by 2020, representing close to two-thirds of total U.S. crude and condensate production. The analysts predict the shale industry will support 1.7 million direct and indirect jobs by the end of this year, rising to 2.5 million in 2015 and 3 million in 2020, with the sector by then contributing more than $416 billion to the economy.
- The North America shale boom is also helping Exxon Mobil beat Mitsubishi Chemical Holdings as a natural gas glut drives petrochemical costs to the lowest in at least four years, undercutting Asian producers who rely on oil-based raw materials. Record gas production has driven down the cost of ethane, a component that’s converted to ethylene, by 60 percent this year and prompted Japan to shut units running on oil-based naphtha that’s up 2 percent. Exxon Mobil and Westlake Chemical are among companies building ethane-fed plants to benefit from shale output that cut gas prices by about 75 percent since 2008. Mitsubishi plans to shut an ethylene unit, partly blaming the “emergence of shale gas” in North America, while Mitsui Chemicals also anticipates cutbacks. Gas liquids, mostly ethane, supply about 85 percent of feedstock for U.S. ethylene makers. Almost all plants in Northeast Asia use naphtha.
- According to Bloomberg news, aluminum stockpiles in the main trading regions in China have climbed to the highest level in two years as growth in supply outpaces demand in the world’s largest user, indicated by two industry surveys. Reserves in Shanghai, Wuxi and Hangzhou, and in Guangdong province increased to about 940,000 metric tons as of October 22, the highest since September 2010, according to Wen Junxiang, head of the research department at Guangzhou KT Commodity Information & Consulting Co.
- The U.S. Securities and Exchange Commission has delayed for a second time a ruling on JPMorgan’s plan to launch an exchange-traded fund (ETF) physically backed by copper. The regulator set a new deadline of December 14 to rule on one of two planned ETFs. It said it needed more time to consider the issues surrounding the fund, which has ignited fears among U.S. copper fabricators about its potential impact on the market. U.S. consumers have fought to have the fund blocked, saying it would disrupt supply and inflate prices by removing available metal from the market.
- The HSBC China October flash manufacturing Purchasing Manager’s Index (PMI) improved 1.2 percent to 49.1 from 47.9 in September. The breakdown of the index shows some positive signs, such as the running down of inventories and improving new orders. The market was encouraged by the improving PMI, though it is still below 50, indicating that industrial activities are in contraction.
- Data from the China Banking Regulatory Commission (CBRC) showed that for the first nine months, loan balances for social security housing constructions at banking institutions went up 47.6 percent on a year-over-year basis, which should benefit construction companies.
- The Philippines cut interest rates by a quarter of a percentage point to a record-low 3.5 percent in the week. This was the fourth time this year to spur growth and dampen currency gains as U.S. monetary stimulus threatens to boost capital inflows.
- Thailand’s September exports were slightly up by 0.2 percent on a year-over-year basis, beating the market consensus which had predicted a contraction.
- Korea’s GDP decelerated to 1.6 percent in the third quarter this year, below the consensus forecast of 1.7 percent. This was the slowest growth in three years since the third quarter of 2009 due to weak capital spending and destocking, but economists said it could be the bottom of the cycle.
- Out of 935 companies listed in the Shanghai Composite, 161 have reported third-quarter earnings with profits falling an average 4.5 percent from a year earlier, but analysts encouraged investors to look beyond reported earnings, rather than paying attention to earning revisions in the reporting season.
- In spite of the market consensus that The People’s Bank of China (PBOC), the central bank, would cut interest rates at least once and cut the bank reserve ratio one to two times before year-end, that hope has diminished lately due to increasing reverse repo operations by the central bank. Similarly, the market may have overestimated the probability of a large stimulus package around the national congress on November 8.
- In its recent research report, JP Morgan predicts Korea’s economically active population to peak in 2012/2013, tracking Japan closely in its economic and population dynamics.
- The graph above shows that money flows into Association of Southeast Asian Nations (ASEAN) countries went up in the third quarter due to the U.S. QE3 program. The increasing inflow of money should help inflate asset prices in these countries, particularly benefiting the equity and property markets.
- HSBC makes an ongoing case for Turkey, even after its very strong run, up 45 percent year-to-date in U.S. dollar terms. The chart below shows that foreign ownership is still low by historical standards.
- Turkish corporations improved their competitive position dramatically over the past five years. Net profit margins expanded as unit labor costs have fallen, the opposite of all the BRIC (Brazil, Russia, India and China) countries.
- Indonesia’s current account (CA) balance turned into a deficit this year due to reduced demand from China for its commodities and lower coal and rubber prices. CLSA forecasts Indonesia’s CA could be worse than India next year, reaching 3 percent of GDP. This widened CA deficit is mostly due to a weak external market, with strong domestic demand for external consumer and industrial goods. A number of economic forces can act to dampen or reduce the impact of the CA deficit, including continuing FDI (foreign direct investment) inflow, global recovery, and productivity-enhancing domestic policies.
- Mark Mobius expressed his concern to the Russian business paper Vedomosti about the fate of minority investors in TNK-BP Holding following its acquisition by the state company Rosneft. Despite consolidation, Rosneft CEO Igor Sechin said that there are no plans for a minority share buyout. Mobius declined to comment how the deal reflects on the investment climate in Russia.
- A BCA Research valuation ranking shows that currencies of commodity-producing nations, such as Brazil, Chile, Indonesia and Russia, are the most expensive, which makes them particularly vulnerable if commodity prices head lower. BCA ranks emerging markets currencies based on an average of two valuation measures: the deviation of the real effective exchange rate from its 10-year mean and purchasing power parity. On the other hand, the Indian rupee has the most upside by this measure.
© US Global Investors