Gold to runA week ago, both
gold and gold sharesappeared to be settling and bottoming out after undergoing aliquidation in July. The liquidation was largely driven by deleveragingcaused by financial shorts going against hedge funds who were also long“inflation” hedges like gold, oil, oil stocks and mining stocks. Thishas obviously been a great “trade” since last August: Financials haveimploded, while resource stocks and commodities have all gone higher.
Gold (or the
GLD ETF)edged a couple dollars lower last week. Gold mining shares once againoverreacted to the downside (as they have on every sell-off in goldsince last August) and edged lower by another 4%, according to the
GDX gold mining ETF.
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Idon’t have a crystal ball, but the same signs that suggested a low wasforming a week ago are still with us today. In fact, these “signs” arenow getting even harder to ignore, even though prices haven’t moved allthat much.
First, take the
XAU/Gold ratio.One can question its relevance when trying to determine peaks andvalleys in gold shares, but its usefulness as a historical indicationof gold share valuations as either undervalued or overvalued relativeto gold is unquestionable.
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On Friday, the XAU/Gold ratio collapsed over 2% to a new 7-year low after
Gold Fields (
GFI)was slaughtered for 15%. This occurred after the company guided downproduction for the second half due to needed maintenance on two of itsmain mining shafts, which then triggered furtherdeleveraging/liquidation in the rest of the large-cap golds as well.The move in the shares on Friday had nothing to do with the price ofgold - but everything to do with selling begetting more selling in thewake of Gold Fields' collapse.
What that collapse hasproduced, however, is a gold mining universe that's probably moreundervalued than it's ever been since the 20-year secular bear marketin gold ended back in late 2000.
As you can see in the chartof the XAU/Gold ratio vs. the XAU (an index of senior gold miningstocks) above, the XAU/Gold ratio has never been this low during gold’sbull market, which began following the 2000 nadir. Valuations of thejunior golds relative to gold are even cheaper than they were in 2000,believe it or not.
Some might say that this ratio has fallenbecause mining margins are contracting due to the high price of oil,which is a large component of mining costs. This was precisely the casefrom March through June, when the gold/oil ratio collapsed back to its2005 all-time low.
Since June, however, this ratio has begun to climb (see the chart below of GLD, the
HUI,the gold/oil ratio, and oil), meaning that gold mining margins areexpanding once again. This is a trend I expect to continue, since oilwill likely consolidate while gold moves to new all-time highs onrenewed investment demand - which should occur during the seasonallypositive period of the year for gold demand, which begins in August andlasts roughly through April.
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Assuminggold continues to rally, what are the odds that this valuationdisparity can continue with mining margins now expanding once again?I’d say close to zero.
Investors are being given a rareopportunity to buy mining stocks at these levels - but the window'squickly closing on that opportunity. As you can see from the XAU/Goldchart above, once a major low is put in for both the ratio and the XAU,the V-like move off the low in the mining shares is fairly swift,almost like a rubber band being snapped.
You might say: “OK,fine. Gold stocks are cheap. But what if gold falls? Why should goldrally, and why now?” In short, there are 4 primary reasons for gold torally and rally soon:
1. Investment demandcontinues to increase. During July, which is typically a seasonallyweak period for gold demand, fresh new investment demand took GLD’sgold holdings up to a new all-time of 706 tonnes, which made the GLDETF the 8th largest holder of gold in the world behind the Japan’scentral bank. On top of that, just this past week,
legendary investor Jeremy Grantham said, "I bought my first gold last week, and I hate gold. It doesn't pay a dividend. I would only do it if I was desperate."
2.Real interest rates are negative all around the world, especially inthe U.S., and will continue to be so as far as the eye can see. That'sinflationary. It’s no coincidence that gold is rallying in all fiatcurrencies as well - not only in dollars, as some might believe.
Evennow, gold is marching back to its recent all-time high in yen, euros,and dollars. As I’ve said before, this is another signal from themarket that the fiat dollar-based monetary system that the world hasenjoyed since 1980 is basically broken. And just as they did after theBretton Woods system broke down in the early 1970s, investors willcontinue to flee to gold as a store of value until the new globalcurrency system is identified.
3. With theU.S. banking system crippled, unemployment continuing to rise and theU.S. sinking ever further into the stagflationary soup, the Fed can’teven begin to think about raising interest rates to combat inflation.That means inflationary pressures will continue to build and supporthigher gold prices. I don’t care how high oil goes or how low thedollar goes, the Fed has
never raised interest rates in its history while U.S. unemployment is rising.
Andeven if we didn’t know that, the Fed’s primary job is keep thefinancial system intact (as I've pointed out repeatedly since lastAugust). That means as long as that system is at risk of completecollapse (as it is now), the Fed will continue to ignore risinginflationary pressures in favor of nursing the financial system withlow interest rates and easy access to credit.
4.As for why gold should rally “now,” as opposed to in a couple of monthsor next year, the positive seasonal period for both gold and goldmining shares begins in August and lasts through next spring, a resultof seasonal jewelry and Indian festival demand. When investment demandcoincides with this seasonal demand, it creates a powerful upside move.Thus, the typical pattern following an early summer low (which in thiscase came in May) would now be for gold and gold mining shares to riseto new all-time highs sometime between now and the year's end, followedby further gains in the early spring of 2009.
Lastly,concerning timing: After writing bullish articles on gold and goldmining shares here on Minyanville over the past couple of years, I’venoticed an interesting pattern regarding reader emails to my
llewis@dailymarketsummary.comaddress. In particular, rare virtual “floods” of gold-related hate mailwould seem to stream in near important lows - and then would suddenlystop. So I began to track the instances of mass hate-mailing back in2007, which I've termed a “Hate Mail Buy Signal.” It's labeled in thechart below.
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Asyou can see, I got two buy signals in a single week last week from thisindicator - which is rare. The only other time this happened was inAugust of 2007, which proved to be a fantastic buying opportunity inboth gold and gold mining stocks.
Will history repeat? Noindicator is foolproof, but when taken in conjunction with all theother bullish factors currently in play, I tend to think it will.