The Gold Mining Sector and spurned lovers!

6 mins. to read

One thing that is always true in financial markets is that investors continuously swing between a love-hate relation with equities or other asset classes. What is also true is that like a spurned lover, the end game usually ends in overreaction. In effect, what is loved today will be hated tomorrow and vice versa.

The collapse of Lehman Brothers in 2008 and the panic that followed led to a redirection of the money invested in equities to ‘safer’ assets like government debt and to other traditional safe havens such as gold. The US Fed had to inject liquidity in order to avoid a total collapse as banks and other financial institutions were simply no longer able to procure short-term funding. This of course helped gold.

But, the subsequent financial crisis was not exactly the chief incentive to buy gold as recessions usually coincide with periods of deflation: typically the type of conditions under which gold’s value tends to diminish, at least as a hedge against price increases. Under the stewardship of “Helicopter” Ben Bernanke however, the Fed initiated one of the most extreme and unconventional expansionary packages ever attempted in monetary history  in order to reflate the economy and attempt to promote full employment.

The Fed also had a new tool at its disposal – quantitative easing. They spent trillions buying government debt and MBS (mortgage backed securities) in order to push investors back into riskier assets. It was a desperate attempt to push the economy back towards its trend rate of growth, with Bernanke anticipating that ZIRP (zero interest rate policy) and QE would encourage an investment boom.

The first consequence of such a plan was of course, initially, a massive rise in the price of gold which, by October 2011, had hit an all-time record near $1,900. With the Fed expanding the money supply and being followed by other central banks across the globe, it was expected that gold would move further into uncharted territory. From Q4 2008 to the Q4 2011, gold rose almost 200% while silver rose more than 350%.

To most experts it seemed that it would be just a matter of time until inflation finally picked up and that could only mean higher gold prices. But, after 2011 metals prices stopped trending higher and started to trade sideways. While central banks were still injecting money, investors began to anticipate a reduction in asset purchases. At the same time, even after trillions of dollars injected into the US economy, inflation did not pick up at all, something which undermined the prospects for the gold price. Then, at the end of 2012 and before leaving the Fed, Ben Bernanke announced the tapering of his QE programme and which prompted concerns among investors that interest rates could start increasing rather sooner than expected. This has contributed to a deterioration of precious metals prices, and of course dragged down the gold miners.

As leveraged bets on gold, gold miners are expected to do better than gold when gold rises and to do worse when it declines. Basically buying the miners is like buying gold on margin. There has however been a disconnect as while gold jumped 21% over the last 5 years, gold miners (here represented by the Market Vectors Gold Miners ETF – GDX) have lost near 60% of their value. Year to date, these gold miners had been outperforming gold, but over the last 3 months they have again come under pressure.

Meanwhile, the S&P 500 has continued to hit all-time highs just recently and we are only a shade under 3% off the peak at the time of writing. The performance gap between the broader market and the gold miners has been rapidly increasing since mid 2011, to such a point that one is up around 60% while the other is down 60% (since mid 2011) – a truly massive disconnect.

Recent economic data in the US has been showing some improvement. The unemployment rate peaked at 10% in October 2009 but has recovered significantly to the current 6.1% level. GDP growth for the current year is expected to be between 2%-2.2% (according to the Fed). Additionally, asset prices are near record highs, having fully recovered the ground lost during the Lehman collapse. While this picture is not the best, at least in terms of economic data it is enough to give investors the impression the worst is now, finally, behind us and that interest rates will start rising from here. As a safe haven, gold does not stand to benefit much from such a picture. However, it is worth noting that gold has risen steadily in the past during times of rapid economic expansion.

By far the biggest problem that gold faces is related to its connection with the money supply, inflation and interest rates. When the dollar was pegged to gold during the Bretton Woods arrangement, the Fed could not expand the money supply at will, as the excess supply of money would lead investors to exchange their dollars for gold and thus lead to the money supply shrinking back to its starting point at which the exchange between dollar and gold was fixed. But the dollar is no longer convertible into gold – it hasn’t been since 1971. Consequently, the Fed can now expand the money supply at will, without any conversions occurring.

With the gold supply relatively stable, an increase in the money supply should press gold prices higher, all things being equal. But with Bernanke announcing a taper of the current QE programme just before leaving the Fed at the end of last year, and with QE now finally approaching its end, the fuel that propelled gold prices is running low. Silver, often referred to as the poor man’s gold, has also been losing value. Mining shares in both metals have also this fallen precipitously in the last few weeks. Meanwhile, in anticipation of a tighter monetary stance, the US dollar has been appreciating dramatically. YTD the dollar is up 6.5% against the euro and 3.1% against the yen and it is the most overbought it has been for near 15 years. Something is likely to give soon as the unassailable economic law of mean reversion will inevitably occur…

It is interesting to note that interest rates are still near zero however and US GDP growth is lukewarm at best. At the other end of the scales, the market-cap-to-nominal-GDP ratio is 125% (a very high value), the FED needs to get rid of $4 trillion in assets, and the US debt-to-GDP ratio is above 100% – and rising. This is not the worst scenario for gold, at least not one that would suggesting selling the precious metal here into such a depressed environment.

Now, coming back to the gold miners, they are down on average between 70% and 90% for the last 3 years, while gold is down 26%. Over the last five years, the values change to minus 60% and plus 23% respectively – a massive disparity between the producers and the “produced”. These companies have been severely punished to a degree that is typical of generational bottoms. We can see in the chart below just how undervalued they are as a measure of price to book.

With the supply of gold becoming very tight and gold grades declining, the supply side going forward is looking very favourable for the industry. The industry also should also see the benefits of the cost cutting that has been instigated over the last few years, which has improved efficiency and suggests higher profit margins in future. In order to highlight just how undervalued this industry appears when compared with gold, observe the following chart, which depicts the ratio between gold miners and gold, here represented by GDX and GLD respectively.

The ratio was above 0.6x in 2006 and has been trending down to the current 0.19x level, which is even lower than it was at the peak of the financial crisis. There is no fundamental reason for this declining ratio, and we expect this point to be an excellent entry opportunity on almost any time horizon going forward from here. What is hated today typically becomes loved tomorrow: rather like a spurned lover but in reverse!!!

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