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Trying to pick a bottom in gold
04/16/2013 5:38 pm EST
There are four different kinds of gold markets right now and they each have different dynamics.
First, start with the gold momentum traders since I think this is the biggest group, is getting most of the press attention, and in the short run exerts the biggest influence on gold prices. Gold’s upward momentum peaked sometime in the fall of 2011 when the yellow metal hit its record all time nominal (that is without taking inflation into account) price at $1,920 an ounce. A high percentage of momentum traders kept their gold positions in the hope that upward momentum would return. But in the last quarter of 2012 and the first quarter of 2013 momentum investors began to move out of their gold positions. $9.2 billion flowed out of gold ETFs (exchange traded funds) in the first quarter of 2013. Gold is now in an official bear market—down 27% through the close on April 15—and I don’t think momentum players are headed back into this market any time soon—at least until they see the technical indicators for gold change.
Second, there are the gold as hedge buyers. This very large group bought gold initially because they thought that aggressively expansive central bank policy had to lead to inflation and they wanted to use gold to hedge against the fall in value of paper currencies. This group has felt under increasing pressure in recent months and weeks as inflation stubbornly refused to go up. Gold, since it doesn’t pay a yield (although some gold mining stocks do,) is a tough hedge to hold when other assets are rising in price and when the date at which the option on rising inflation will pay off keeps getting pushed off into the future. For many in this group yesterday’s report of lower than expected 7.7% first-quarter GDP growth in China was the final straw since it edged the global economy further away from inflation (in the consensus opinion) and closer toward deflation. I don’t see this group coming back into the gold market until it sees evidence that it needs to hedge inflation.
Third, there are—or maybe I’d better say “were”—those who jumped on the gold bandwagon because they had become convinced—many quite recently—that gold was a safe, can’t lose, guaranteed to go up investment. I think the sell off has been enough to convince many of this group that gold isn’t any such thing. I think this group is a likely source of some buying on the dip—some late converts to gold will see a dip as a chance to get in on the gold story at a lower price. But I think this group is likely to be a much bigger source of sellers on any bounce. I think the plunge in gold prices caught most of this group by surprise and market history tells me that many will be hanging on here for a chance to sell at something closer to their purchase price.
Fourth, there is a relatively small group that liked the fundamentals of gold supply and demand. To this group growing demand for gold created by rising incomes in countries such as India and China was headed to a collision with rising costs of mining gold. That put gold in a similar position with commodities such as copper where prices were headed up in the long term because of this demand/supply dynamic. If you saw gold from this point of view, you probably preferred the stocks of gold miners to gold itself. And you looked for gold mining companies with rising reserves and production and lower than industry average costs. I’d put myself in this camp. From this point of view, momentum and gold as a hedge players provided a potentially profitable extra source of demand for gold. But it’s the long-term trend in the mining industry that was the initial attraction. For better or worse, I don’t think this group is large enough to move the gold market higher although investors and traders with this point of view are likely to be the first back into the gold market and to provide the beginnings of base building in future months.
I think the perspective of this last group on gold fundamentals also gives investors and traders the best take on where a bottom for the gold market might be. At some point between $1100 and $1300 an ounce—depending on what analyst is doing the calculations—the all-in cost of mining gold exceeds the price of gold at a significant percentage of the world’s gold mines. At that point, gold miners who haven’t hedged the sale of their future production (and the industry has been doing less and less hedging as gold prices rose) will find that it costs them money to mine gold at their least efficient mines and some will begin to cut back on production. That reduction in supply will—at some point—put a floor under gold prices and indeed lead to a recovery in the price of gold.
Where is that point? For example, back at the beginning of March I wrote http://jubakpicks.com/2013/03/04/gold-mining-stocks-take-another-hit-from-better-accounting/ about an analysis by Credit Suisse that put the point at somewhere around $1450 an ounce. More recently (April 12) Dundee Capital Markets pointed to $1300 an ounce as the make or break point. At that level, Joseph Wickwire, the manager of Fidelity’s Select Gold Portfolio told Bloomberg, about 30% to 40% of mine production probably isn’t cash flow positive.
I think those make/break cost calculations may be a bit aggressive and I suspect that mining companies will keep cash flow negative mines running even below the break even point, but somewhere about $1200 to $1250 I think we would see some reductions in sales as companies decide to stockpile gold rather than sell it below cost. If market sentiment outruns fundamentals as it usually does (both to the upside and the downside) that would suggest something like $1200 as a point where I’d be comfortable buying gold and gold mining stocks. That’s roughly 12% below the $1360 an ounce of April 15.
And, of course, if you believe this analysis and want to apply it to gold mining stocks, you’d look for gold miners with rising (and not falling ore grades), with relatively low-costs and relatively low cost opportunities to increase production, and with rising production. Two stocks that come to mind are Yamana Gold (AUY) and Randgold (GOLD.) I wouldn’t buy them yet because I suspect that gold has further to fall despite any bounce today. But these are two I’d like to get—or buy more of--at the bottom.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own positions in Randgold and Yamana Gold as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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