Where’s the Beef for Gold Equities?

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

Gold bulls have plenty of room to graze in the stockyard these days as the investing herd migrated to other assets during the market’s steep climb in 2012. For the fourth time in the past year, gold bears outnumbered the bulls in Bloomberg’s weekly Gold Bull/Bear Sentiment Survey. In fact, the bears had the bulls outnumbered by almost 2-to-1.

Today’s growing sloth of gold bears is a “buy” signal for contrarian investors like us at U.S. Global. Research from the gold team at Canaccord Genuity found that gold rallied about 10 percent on average during the month following each of these sentiment “cross-overs.” This historical increase means that gold could potentially rally to the “high $1,700’s per ounce,” which Canaccord believes “would breathe some new life into the gold equities.”

After a year of neglect from investors who favored bullion, gold equities need resuscitation. Going back to April of last year, gold stocks have been undervalued compared to bullion. I discussed this disconnect back in June 2011 (Will Gold Equity Investors Strike Gold?) and again in August (Valuation Gap Makes Gold Miners Attractive, but All Miners Aren’t Created Equal).

This trend has been accelerating recently: At the end of March, the spread between the NYSE Arca Gold Miners Index and gold bullion was at the same extreme level it was during the 2008 credit crisis despite a much rosier global economic outlook. Going back the full decade of gold’s bull run, this is quite a rare event.

It hasn’t been a complete drought for gold equity investors though, as there have been occasional spurts of relief over the past year. From the beginning of 2011 through the middle of the year, the S&P/TSX Global Gold Index declined by 14 percent. The index then quickly reversed course upward during the market’s volatile period last fall. Now, the index has been declining for four months now, dropping 28 percent, while gold bullion has only fallen 9 percent over that same time period, says Canaccord.

Believe it or not, the four-month selloff is a bullish sign for gold stocks. If you expand your time horizon, you’ll see each dip has been a turning point for gold stocks. Canaccord says that, “sector weakness (less than one year) in the gold equities over the last six years has typically ended with “V” shaped corrections to the upside.” Gold investors must be quick to “buy on the dips” since these sharp V-shaped corrections have been frequent.

The Stampede to Buy Undervalued Gold Miners

If you plan on shopping for bargains in the gold miner department, you’re going to have to fight a crowd. Numerous global investors have been pounding the table for gold stocks, including Dr. Marc Faber who said “gold shares have become extremely oversold and could rebound in the next few days” in his April market commentary and Global Portfolio Strategist Don Coxe, who reiterated that gold equities are undervalued compared to the precious metal on his weekly conference call today.
Another big buyer has been the miners themselves. Mergers and acquisitions in the mining sector have been at an all-time high over the past two years. Large gold miners such as Barrick, Goldcorp and Kinross have been taking advantage of these cheap valuations by snatching up small miners with proven deposits.

And they’ve been willing to pay a premium too. According to Desjardins Capital Markets, over 2010 and 2011, a total of 26 mergers and acquisitions have taken place to the tune of more than $30 billion. In this time period, the buyout or purchasing premium has averaged more than 40 percent.

Desjardins says the M&A trend in the gold sector should continue, given “growing cash hoards and a lack of new discoveries” of the precious metal. As one example of this ongoing worldwide trend, Bloomberg News reported today that, “Chinese gold producers are vying for domestic and overseas mining resources,” with two companies competing for two different gold mining companies located in the eastern province of Shandong.

Big miners have historically purchased the known assets of their rivals as a way to increase reserves rather than deal with the heartache and headache of drilling core samples and filling out permit applications. Large-scale gold production is a complex and costly process involving digging, transporting, crushing and chemically treating massive quantities of rock to get at small amounts of gold. In fact, a commercially viable deposit could contain just a tiny fraction of an ounce of gold for every ton of mined rock. If you’re curious about this phenomenon and want to learn more, check out my book The Goldwatcher: Demystifying Gold Investing where I go into greater detail.

 

With the signals there for a bounce and stocks undervalued, what’s stopping investors from buying gold equities? One reason could be margin pressure. Rising energy costs, reduced supply and currency swings can quickly erase a gold company’s margin. It takes a great deal of diesel fuel to run the shovels and dump trucks that haul ore to the mill for processing and rising energy costs can affect the profitability of a mine substantially. These variables are the project’s cash costs, or how much capital must be spent to pull an ounce of gold out of the ground.

From the first quarter of 2008 through the third quarter of 2011, the global average cash cost has been rising for miners at a rate of about 8 percent year-over-year. Desjardins says costs will “likely remain under pressure, especially on the energy and labor fronts.”

However, as Desjardins points out, at the level that gold is at now, “most producers will be generating significant cash flow and earnings,” using this cash to fund takeovers, build out development pipelines and pay higher dividends.
Another barrier for investors could be perceived volatility. On Bloomberg Radio, I explained to host Kathleen Hays how gold’s 12-month rolling volatility is very different from the way it’s perceived. While the normal volatility for the S&P 500 Index is up or down 19 percent over a 12-month period, it’s only 13 percent for gold bullion.

My friend and CIBC analyst, Barry Cooper heard my Bloomberg interview and emailed me the chart below showing how the TSX Global Gold Index ETF/Gold Price Ratio has historically been negatively correlated with gold’s volatility. Two times over the past four years, when gold price volatility was falling, it was generally associated with rising valuations of the TSX Global Gold Index ETF. Today it’s a different story: Gold’s volatility and value are both going down. According to Barry, “either we are in a totally new regime for gold shares or something has to give.”

The cold shoulder from investors has also given way to a promising trend in the gold space—growing dividend payouts. We believe this is one can’t-miss trend. We’ve been paying close attention to this as it has developed over the past few years, because through monthly or quarterly dividends, investors can receive income while they wait for share prices to appreciate. To capture the income potential, we’ve adjusted the portfolios of USERX and UNWPX to hold some of these dividend-payers. Many of these holdings pay a monthly dividend that is higher than the two-year government not e, have rich balance sheets and receive royalties from all over the world on their gold mines.

We encourage investors to think contrarian: Eat up all you can while the pasture is wide open, because as the chart above shows, when gold equities reverse, it happens quickly.

Watch Frank Holmes’ “Can Gold Continue to Glitter?” interview on CNBC now.

 

Index Summary

• The major market indices headed lower this week. The Dow Jones Industrial Index fell 1.61 percent. The S&P 500 Stock Index decreased 1.99 percent, while the Nasdaq Composite finished 2.25 percent lower.
• Barra Growth outperformed Barra Value as Barra Value finished 2.11 percent lower while Barra Growth fell 1.89 percent. The Russell 2000 Index closed the week with a loss of 2.68 percent.
• The Hang Seng Composite Index rose 0.44 percent; Taiwan rose 1.06 percent, while the Kospi fell 0.99 percent.
• The 10-year Treasury bond yield fell to 1.98 percent, falling 20 basis points for the week.

 

Domestic Equity Market

 

The S&P 500 Index fell 1.99 percent this week, the biggest weekly drop this year as concerns mounted over a global economic slowdown and financial imbalances in southern Europe.

 

Strengths

• Supervalu was the best performer within the S&P 500, rising 25 percent. The company reported earnings that are more or less even with expectations, but the stock appears to have benefited from a significant short squeeze.
• Consumer discretion was the best performing sector, as the homebuilders bounced back from last week’s weakness to be the top industry group this week.
• Other strong performers for the week include Hewlett-Packard, Starbucks and Safeway.

Weaknesses

• The financial sector was the worst performer this week as European concerns resurfaced and initial earnings reports within the sector met expectations.
• The energy sector was also weak on concerns of global economic weakness.
• F5 Networks was the worst performer this week, falling by more than 10 percent as a sell side-analyst raised concerns that the company may have had to push really hard to close deals at the end of the quarter, potentially increasing the odds of an earnings miss.

Opportunity

• The market didn’t respond positively to early earnings reports and suffered its worst week of the year. This may set a precedent for next week as earnings releases are set to pick up.

Threat

• The S&P 500 is arguably still overbought in the short term and could be vulnerable to profit taking after the rally in the first quarter.

 

The Economy and Bond Market

 

Treasuries rallied this week, sending yields sharply lower. The nonfarm payrolls report that was released on Good Friday disappointed and with negative rumblings out of Europe, it was a “risk off” week. China reported first quarter GDP growth below expectations, which increases the likelihood of additional policy accommodation from the Chinese authorities in the near future. 

Strengths

• Natural gas fell below $2 this week, providing consumers with some relief to higher gasoline prices.
• Several inflation data points were released this week and were overall in line with expectations. This is generally supportive of the existing Federal Reserve policies.
• Wholesale inventories rose 0.9 percent in February, indicating continued restocking that should boost first quarter GDP in the U.S.

Weaknesses

• March nonfarm payrolls grew a modest 120,000, well below market expectations.
• Weekly initial jobless claims jumped to 380,000 this week, the highest reading since January.
• Spain remains in the spotlight as yields spike higher and investors remain nervous about long-term solutions for the country’s financial woes.

Opportunity

• The weak Chinese GDP number implies that the current global easing policies are likely to remain in place for the foreseeable future.

Threat

• Rising oil and gasoline prices, combined with liquidity implications of global easing led by Europe, may raise the prospect of higher inflation going forward. 

 

Gold Market

For the week, spot gold closed at $1,657.35 up $21.12 per ounce, or 1.6 percent from Thursday's close before Good Friday. Gold stocks, as measured by the NYSE Arca Golds BUGS Index, rose 2.7 percent. The U.S. Trade-Weighted Dollar Index declined 0.3 percent for the week.

Strengths

• On again, off again speculation that the Federal Reserve may need to intervene with more stimulus to shore up the economy led gold to a relatively good week. Both China and the U.S. posted weaker economic data. China’s trade surplus came in at $5.35 billion, substantially greater than the median projection of a $3.15 billion deficit. The weak numbers raised concerns that the world’s second-largest economy faces a deeper slowdown than originally forecasted. In the U.S., nonfarm payrolls rose 120,000 in March, well below market forecasts and a possible sign that momentum in the job market is slowing.
• Randgold Resources jumped 9 percent on Monday on news that a political settlement appears to have been brokered in Mali. Leaders of the recent coup have come to an agreement with the military junta to reinstate the country’s constitution.
• In other positive news, jewelers in India called off their three-week strike over the prior weekend. The Indian government said it would consider scrapping a budget proposal to levy an excise duty on unbranded jewelry. Industry representatives said that if the tax rollback does not materialize the strike would resume on May 11.

Weaknesses

• Technically, silver prices are not following through with the same price strength as gold.  Analysts cite record-high mine supply and demand concerns. In addition, the huge price volatility last year, when the metal crashed 35 percent in a matter of days on two occasions, has dampened silver’s appeal to investors as a cheaper alternative to gold.
• For the second time since February, the CME Group, the largest operator of futures exchanges in the U.S., announced a cut in margin requirements for COMEX silver futures in an attempt to boost liquidity. However, analysts note that margins are still higher than they were last year and it would take some significant interest from investors to drive the price higher.
• The latest Gold Fields Mineral Services (GFMS) report noted that gold prices are expected to be driven by eurozone debt concerns and the prospects of additional monetary stimulus. In their view, gold has the potential to breach the $2,000 per ounce level in 2013. The report also said total cash costs increased 15 percent in 2011 to $643 per ounce, up from $560 per ounce in 2010. Declining mine grades are the largest contributing factor to the increase, contributing $28 of the $83 per ounce net increase. All-in costs (including depreciation as well as general and administrative charges) increased 22 percent.

Opportunities

• Positive economic signs and the rollover of bad European debts through their long-term refinancing operations (LTRO) program pushed the S&P 500 to good returns in the first quarter. However, it is unlikely the recent bright spots are enough for the world’s two great fiat currencies to regain trust from Asia, Russia and the Persian Gulf states. Short-term liquidity issues have been addressed but unsustainable levels of sovereign debt still remain. Western central banks will likely have to keep printing money for some time and those countries with surpluses will have to find a suitable place to park their growing foreign reserves. Currency devaluation has historically been a major policy tool for extinguishing national debt but it also leads to a higher gold price.
• Russia has publicly stated it is raising its gold weighting to 10 percent of its reserves. China, which would like to raise the renminbi to reserve currency status, is eying large gold reserves as well. With official gold reserves sitting at 1,054 tons, China has a long way to go before it can catch up to the 8,000 tons of gold held by the U.S. and the 11,000 tons of gold held by the eurozone. China would likely need to boost the country’s gold holdings in a significant way in order to make its currency competitive in world markets.
• HSBC gold analyst James Steel says that the marginal cost for mining gold, when miners leave low-grade ore in the ground, is about $1,450. Despite a four-fold increase in investment, a lack of great new gold discoveries has made peak gold production a closer reality than peak oil. With world gold output stuck at 2,700 tons for a decade, this creates a natural floor, of sorts, for gold prices.

Threats

• David Rosenberg had some interesting comments on incomes and prospects for a strong recovery in the household sector. The sector has recently been going through the healing process, but is still far from healed. Rosenberg also notes that current real disposable incomes are actually lower than in May 2008 on a per capita basis, $32,600 today versus $34,631 then. Rosenberg says, “You can see why it is that for most people, it is very difficult to talk about economic recovery when real personal incomes have done so poorly and for so long.”
• A recent paper from the African Development Bank (ADB) titled “Gold Mining in Africa: Maximizing Economic Returns for Countries,” points out that gold mining is significant activity in at least 34 of the continent’s 54 countries. The paper notes Africa’s annual gold production is 480 metric tons, 20 percent of annual global output, but concession agreements signed by the governments are unfair. This particularly applies to the royalty rate stated in these agreements. Despite spiraling prices for precious metals, the ADB believes Africa is not cashing in enough from its large gold resources. These agreements severely limit gains from gold mining activity in gold producing countries. However, only a limited number of African countries have actually taken equity stakes in the mines within their borders. It’s worth pointing out that one can only gain access to market returns by risking capital to invest.

 

Energy and Natural Resources Market

 

Strengths

• China's monthly steel exports exceeded 5 million tons in March for the first time since July 2010, according to Chinese Customs data. Exports increased to 5.03 million tons in March, up 48.4 percent month-over-month and 2.4 percent year-over-year.
• Supporting our food and agriculture investment theme, grain imports by China advanced to the highest level in at least seven years in March as the world’s most populous nation stepped up overseas purchases to meet rising demand. China imported 1.64 million metric tons of cereals and cereal flour in March, compared with 280,000 tons a year ago, the highest figure since at least January 2005. Imports in the first quarter totaled 3.84 million tons, up six-fold from a year earlier. “Grains imports are on a rising trend because of limited arable land, water and labour, at a time when demand is growing amid increasing incomes and changing diets,” said Li Qiang , managing director and chairman at Shanghai JC Intelligence Co.
• Soybeans have been the star performer among the agricultural complex so far this year, with spot prices up just over 20 percent compared to small price declines in corn and wheat. Part of this divergence reflects downgrades to the South American soybean crop. Further deterioration in China’s increasing import requirements for soybeans has also contributed.
• The International Energy Agency (IEA) reports that OPEC crude oil production increased to 31.43 million barrels per day in March, the highest level in more than three years.
• Summer demand continued to drive spot prices for Asian liquefied natural gas (LNG) higher this week with May delivery contracts rising to over $16.50 per million British thermal units (mmBtu). With the majority of its nuclear capacity still offline, Japan, the world’s largest LNG importer, was expected to continue stocking up on the fuel as it heads into summer. "Prices are over $16 and could be headed to $17 on the assumption that the Japanese will top up," one market source said.

Weaknesses

• Natural gas futures fell below $2 per mmBtu this week, the lowest price in 10 years as forecasts for mild weather across the eastern U.S. signaled demand may fall even more.
• Overall mining output in South Africa fell 14.5 percent on a year-over-year basis in February as a six-week long strike at Impala Platinum’s Rustenburg mine and the government’s safety-related inspection and work stoppages hit platinum and gold production. Gold and PGMs output dropped 11.5 percent and 47.6 percent year-over-year in February, respectively.
• Aluminum products maker Novelis Inc, which cut its fiscal 2012 earnings estimate because of lower shipments and soft demand, will close its Saguenay Works in Jonquiere, Quebec in August.

Opportunities

• Comments made by the chairman of India’s top iron ore miner indicate a sharp decrease in future exports of iron ore from India. Given increased domestic steel production and government restrictions on both iron ore mining and exports, NMDC’s Narendra Kumar Nanda predicted that India would export only 30-40 million metric tons in the next fiscal year (April 2012 through April 2013). This projection represents a significant drop in exports from the world’s third-largest supplier. India exported 46 million metric tons of iron ore during the first nine months of the 2011-12 fiscal year, down 30 percent from the prior year.
• Investment bank J.P. Morgan filed paperwork to list a copper-backed exchange-traded fund (ETF) with NYSE Euronext. J.P. Morgan Commodity ETF Services filed a proposal to list and trade shares of JPM XF Physical Copper Trust in a filing dated April 2, 2012. The filing is the first sign since mid-2011 that the ETF, a security backed by physical metal, is likely to list. J.P. Morgan first logged a filing for shares of the ETF in October 2010, the same time as a similar filing by Blackrock. These filings against a tight supply backdrop helped fuel a rally in copper prices to record highs above $10,000 a ton in February 2011.
• Russian President-elect Vladimir Putin outlined proposed new rules for development of the country’s vast offshore oil and gas resources, offering some tax breaks for the far-flung projects. Putin offered to cancel export duties on oil and gas from new offshore deposits and proposed to introduce a lower mineral extraction tax for complex hydrocarbon projects in the Arctic. He also pledged that the new rules will be in effect for at least 15 years from the start of industrial output and offered Russian non-state companies access to the offshore oil and gas.
• Reuters cites Vale CEO Murilo Ferreira as stating Chinese demand for iron ore will remain strong. "Those who have been betting against Chinese growth since the 1990s will be wrong again," Ferreira said. "China is just getting going.” To help meet that demand, Vale expects to invest more than $50 billion to expand iron ore, nickel, copper, fertilizer, coal and other mining output.
• Japan’s zinc demand may increase 7.2 percent to a four-year high this year as the economy recovers from an earthquake and tsunami as the weaker yen helps boost exporters, Nobuyuki Nakamoto, GM at Mitsui Mining & Smelting’s zinc business said. Demand will rise to 537,400 metric tons in 2012, up from 501,200 tons in 2011.
• The IEA estimates effective OPEC spare capacity (which excludes Iraq, Libya, Nigeria and Iran) fell to 2.54 million barrels per day in March. This is down from 2.75 million barrels per day in February, reflecting the removal of Iran from the count. Deutsche Bank commodity analysts think that supply disruptions, not only from Iran but a number of non-OPEC countries, will persist this year due to political disputes and weather disruptions. This means spare capacity levels are likely to remain eroded and below 3 million barrels per day for the rest of this year.

Threats

• Chinese data for March shows that real GDP grew 8.1 percent year-over-year in the first quarter of 2012. However, the moderation from 8.9 percent growth in the previous quarter is consistent with the weak monthly data, especially for January and February, already released.
• The Energy Information Administration (EIA) is expecting electricity generation from coal in the U.S. to decline by about 10 percent in 2012. In contrast, natural gas-fired electricity generation is forecast to increase 18.7 percent on a year-over-year basis. 
• Spain's foreign minister has reportedly sought an urgent meeting with Argentina's ambassador in Madrid to seek clarity on the Argentine government’s intentions regarding YPF. Persistent rumors have suggested that the current Argentine administration is planning to renationalize the explorer, which is majority owned by Spain’s Repsol.

 

Emerging Markets

Strengths

• China’s new loans were RMB 1.01 trillion in March, better than Bloomberg survey of RMB 797.5 billion and amount of new loans in February. In addition, China’s money supply (M2) grew 13.4 percent in March versus an estimate of 13 percent. By the end of March, China’s foreign reserve went up to $3.31 trillion by the end of March; indicating China had reversed the capital flight that began during the fourth quarter of last year.
• A 5.3 percent rise in inbound shipments and 8.9 percent increase in exports from a year earlier created an unexpected trade surplus of $5.35 billion for China, substantially different than the medium projection of a $3.15 billion trade deficit.
• China’s passenger car sales to dealerships rose 4.5 percent in March, exceeding the estimate of 3.9 percent. March retail sales and fixed asset investment also outpaced estimates, rising 15.2 percent and 20.9 percent, respectively.
• China’s Housing Ministry suggested a policy of withholding new home sales permits to developers unless at least 70 percent of their previous projects have been sold out, the National Business Daily says. If it becomes a policy, it should positively impact inventory and may clear the way for new projects.
• Improving electronics shipments drove a 14.6 percent rise in Philippines exports in February, beating estimates.
• South Korea’s workforce increased by 419,000 jobs in March, pushing the country’s unemployment rate down to 3.4 percent. All Asian countries have full employment.
• Turkey’s current account deficit (CAD) narrowed to $75.2 billion for the 12 months ended February 2012. The share of foreign direct investment (FDI) also strengthened.

Weaknesses

• Higher food prices pushed China’s Consumer Price Inflation (CPI) up 3.6 percent (year-over-year) in March, more than the forecast. Meanwhile, the Producer Price Index decreased in-line with expectations. Most market watchers believe China’s food prices will stabilize in the coming months.
• China’s GDP grew 8.1 percent during the first quarter, lower than market expectation of 8.3 percent. The market reacted positively to the number as many believe that it might be the bottom for China’s GDP growth this year.
• GDP growth in Russia had decelerated to 3.9 percent on a year-over-year basis in January 2012, according to Russia’s Ministry of Economic Development. This is down from the estimated 4.9 percent growth in the fourth quarter of 2011.

Opportunity

• China’s new loans were RMB 1.01 trillion in March, better than Bloomberg survey of RMB 797.5 billion and amount of new loans in February. The composition of new loans shows improvement of household long-term borrowing. These are usually mortgage loans, indicating housing market is normalizing. During a visit to Southern China, Premier Wen Jiabao reaffirmed that the government will “fine tune” its economic policy preemptively and the jump in inflation won’t change the government’s direction of monetary policy easing.

Threats

• The Chinese economy is still in the process of a soft landing, and first quarter’s soft GDP growth may not indicate the bottom of a slowing economic activities. Second quarter may need policy support to help reverse the slowing trend.
• Weak private consumption in Poland is the main downside risk to 2012 GDP growth, alongside the expected slowdown in public investment.

 

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