Following on from my last piece about the current collapse in gold and gold mining stocks, this is starting to look more and more like a capitulation event. And as we all know, for a market truly to bottom it first needs to capitulate.
To recap what I wrote yesterday, I believe that the market for gold is going through a fundamental change. Gold itself is fast transforming from a crisis trade, in anticipation of the financial system collapsing or blowing up in a hyperinflationary boom, to a fundamental play supported by the true cost of production. An investment company, called Hebba Investments, has been publishing a series of research reports on Seeking Alpha for the last few years. They have developed a model to calculate the all-in production costs of the world’s largest listed miners. In their latest note they estimated that the average all-in production costs for these companies (accounting for more than 25% of the world’s supply) were $1,221.75/oz during Q3 2013.
At this very moment gold trades at $1,215/oz.
Whether or not you trust Hebba’s figures, read through the latest announcements by the major gold mining companies and you will immediately see a pattern of cost cutting developing across the board. It does not take a genius to figure out that the drop in the price of gold is forcing these businesses to react. When you factor in Barrick Gold Corp’s (ABX) recent $3billion fund raising and this is further evidence of the fundamental challenges now facing the industry.
No-one is expecting $2,000/oz in the medium term, but was anyone expecting <$1,200/oz?
Cost-cutting and capital-raising are relatively easy short-term fixes to shore up balance sheets and bolster P&L’s. However, these will almost certainly only prove to be a precursor to the scaling back of mining operations. To have a more enduring impact on bottom lines, mining companies know they must limit supply. Reducing production at or even closing mines is not a trivial matter and takes time. Yet, it is nearly impossible to believe that this will not happen. Industry reactions to the ebbs and flows of business cycles are established and predictable. Marginal mines will be the first to go, but it is quite possible that higher grade production will also be limited.
This might not lead to a huge surge in gold prices, but even a sustained move to $1,400/oz from here would “only” be a 15-17%% increase and is not beyond the realms of possibility. Were such a fundamental move to happen then there could be disproportionately large gains in the mining sector.
One of our favourite gold mining ETFs is the GDX and it serves as an excellent proxy for the gold mining sector. We’ve written about it several times on the blog over the summer. Below is a chart comparing the price performance of the GDX to that of gold over the last year:
Gold is down 28% while the GDX is down 56%.
Irrespective of anything else that happens in the market, this divergence will have to correct itself. At the moment the consensus is that gold is going to fall off a cliff. There is an argument that the gold mining stocks have simply been falling in anticipation of that. We’re not buying that argument.
The next chart is the GLD ETF’s movements over 2013;
The standout feature of this chart (apart from the obvious price drops!) is the spread of volume. In the first half of the year, when gold fell it fell hard on massive volume. The latest falls however have not seen such panic. This strongly suggests that whatever institutional and retail money is left in gold isn’t in a hurry to get out, in spite of the all the headlines about this market being toast.
It is quite possible that further falls in the price of gold are still to come, but the mood definitely looks much more secure now than it did from February through to the end of July.
However, there is a massive discrepancy between recent negative volumes in gold compared to that in the miners. Take a look at the GDX’s progress over 2013:
Now, this chart looks more like panic!
Volume has intensified over the year, reaching a crescendo in the last few weeks. This pattern is also reflected across other gold mining related ETFs, such as the GDXJ and NUGT. Perhaps this is a delayed reaction to gold’s precipitous drop in H1 and a lower price environment.
In fact, there is probably every chance that this is exactly what has happened, but remember one thing. Most retail investors get into the market at the wrong time, as we are seeing on a daily basis in almost all other sectors, and they get out at the wrong time. You could interpret the intensification of selling on higher volume as an incredibly bad sign, but remember there are buyers on the other sides of those trades.
Our take is this – institutions are loading up on gold mining stocks, taking full advantage of the generational value lows this sector is now in.
A few weeks ago, I wrote a fairly tongue in cheek piece suggesting you should mortgage your house and buy mining stocks. Well today I feel far more bullish. Forget mortgaging just your house; mortgage your granny if you can!
On a 12 to 24 month timeframe this market looks like one of the greatest gifts you will ever receive.